Capitalize smarter, not harder

Merely raising capital requirements won’t prevent a meltdown

Suppose for a moment that there are two farmers, Jim and Bob. Jim grows tomatoes, and Bob grows corn. Both crops take tractors to produce. Normally, corn and tomatoes are equally profitable, but this year, corn is expected to be 15 percent more profitable than tomatoes. Accordingly, Jim would like to loan out his tractors to a corn farmer and split the extra profits, while Bob is looking to borrow some tractors from someone else.

Because Bob and Jim don’t know each other, and because finding each other serendipitously and negotiating terms would be too difficult, the two men instead go to a financial intermediary — a bank. For now, let’s make two assumptions: first, that Jim and Bob live in a barter economy (tractor loans will be repaid in kind); and second, that the bank has no reserve requirement — it can loan out every tractor that is deposited into it. The bank offers Jim a deal: if he loans 100 tractors to the bank for one year, it will return his tractors at the end of that year. Jim will also get 107 extra tractors to produce tomatoes with the next year — a 7 percent return on his investment. Similarly, the bank offers Bob a deal: they’ll loan him 100 tractors, and next year he’ll give them 108 tractors — an 8 percent interest rate. Both farmers stand to gain, so they accept the offers. Of the 15 percent gain that was made from switching Jim’s tractors to corn production, 7 percent goes to Jim, 7 percent goes to Bob, and the remaining 1 percent goes to the bank for bringing Jim and Bob together.

Now, let’s say that the bank has a reserve requirement. For every 5 tractors that are lent to it, the bank needs to keep one in its vaults, just in case. How does this affect the best deal that the bank can offer to Jim and Bob?

If Jim decides to deposit 100 tractors in the bank, the bank will only be able to lend out 80 of those tractors, while 20 will sit idle. For the use of his tractors this year, Jim is going to demand at least 100 tractors next year. Meanwhile, Bob is not willing to pay more than a 15 percent interest rate: the most tractors he will offer to the bank next year in exchange for 80 tractors this year is 92. Even though society would be better off with Jim loaning his tractors to Bob, the restrictions of the reserve requirement cause Jim to continue farming tomatoes, and Bob to grow only as much corn as his current tractor fleet allows.

Adding currency to this picture is an improvement, but only in select circumstances. In scenarios in which the reserve requirement is not enough to discourage Jim and Bob from making their mutually beneficial arrangements, a medium of exchange means that there won’t be actual tractors mouldering in someone’s vault, and the would-be losses from those idle tractors will appear as a benefit to society in the form of lower prices. However, in marginal cases — like the reserve requirement example provided earlier — Jim will still not loan his tractors to Bob. The reserve requirement distorts the rate of return, and by preventing the re-allocation of resources, creates a net loss to society.

Why then, one might ask, do we have reserve requirements on banks at all, if every non-zero reserve requirement is a market distortion? The answer is that reserve requirements help bank regulators differentiate between banks that are insolvent and banks that are illiquid, which allows for bank deposits to be guaranteed while minimizing the risk of banks abusing that guarantee.

Suppose one day Jim comes by to withdraw his deposits from the bank, but the bank can’t accommodate him. There are two potential causes:

The first possibility is that the bank is illiquid. Jim has come asking for his tractors earlier than expected, and Bob has not yet harvested his crop. As soon as Bob’s investment pays off, he will repay the bank and the bank will be able to repay Jim. But until then, the bank has a liquidity problem — while the bank has the assets to cover Jim’s request, it cannot do so immediately.

The second possibility is that the bank is insolvent. The problem is not that Jim has come for his deposits too early, but that the bank has squandered his deposits on poor investments. Perhaps rather than loaning out Jim’s tractors to Bob, the bank went down to the local casino, put the tractors on red at the roulette table, and lost.

The government is obliged to guarantee Jim’s deposits because without such a guarantee, much of modern banking would be impossible. Accordingly, the government is also obliged to respond when a bank is unable to meet its deposit demand. In the first scenario, it is in the best interests of all involved for the government to act as a lender of last resort to the beleaguered bank. But in the second scenario, no loans should be made — the bank does not have the assets to cover its liabilities, it is bankrupt, and the government should take ownership of the bank and divvy up its remaining assets before further losses of Jim’s deposits occur.

Without a reserve requirement, the only thing separating a misjudgment of the bank’s asset value on the part of the government and a loss of public moneys would be the fraction of a bank’s liabilities that are not publicly guaranteed. Stockholders in the bank, for example, are not insured — a bank financed by half equity and half guaranteed deposits could lose up to 50 percent of its holdings before any harm came to the taxpayer. Reserve requirements add an extra layer of protection: given a large enough reserve requirement, there could be zero risk to guaranteed deposits.

In practice, reserve requirements are used sparingly relative to capital requirements. Capital requirements are similar conceptually, but while reserve requirements are designed to prevent the loss of guaranteed deposits by forcing a bank to keep some of its funds perfectly secure, capital requirements seek to prevent the loss of guaranteed deposits by preventing banks from creating huge risks for themselves. Capital requirements dictate the types of investments and bets that a bank can make. If Jim’s bank insists on investing in an asset with a highly variable return (like a chip marker on red at the casino), it is going to have to make up for that risk with safer bets elsewhere. In contrast, a bank that invests in Bob’s tractors is going to be able to loan out more of its funds. Like reserve requirements, the strictness of capital requirements represents a trade-off; on one hand, they promote saving by making guaranteed deposits viable, but they also discourage saving by distorting downward the rate of return.

In the aftermath of one of the greatest liquidity crises our nation has ever faced, there is an understandable call to tighten capital requirements. Upon realizing that the risks of socialized losses were greater than we thought, it makes perfect sense to recalibrate how we make our trade-offs. However, the problem that led to the bust of our financial system was not that capital requirements were too loose, but rather that they were too dumb, and were susceptible to a common-cause failure.

What underpins our current capital requirement system is risk-weighting of a bank’s capital. Very little in the way of reserves are necessary if a bank is holding mostly AAA-rated debt, but if it’s holding junk bonds, the amount it can loan out will be very limited. This makes sense, given the government’s goal of securing guaranteed deposits — if a bank isn’t putting all of its stake on red at the casino, then less reserves are needed to make sure a bank’s losses don’t exceed its non-guaranteed liabilities.

The problem with this risk-weighting is in determining what is risky. Much has been made of the poor bets on housing made by our financial system. What is less talked about is the reason why so many different, self-interested organizations independently made the same investment mistake. That reason is simple: the rating agencies that grade debt made a large error in judgment and rated many types of mortgages as much safer than they actually were. As a consequence, our capital requirement system incentivized every bank to purchase mortgage debt and hold it as an asset. Even if a bank had an accurate picture of the debt’s actual worth, they would still be willing to pay more than the asset’s actuarial value, because holding that debt would free them to make more investments than they would otherwise be allowed.

Normally, errors in judgment in the financial system even out. For every person with an overly optimistic view of tomato futures, there is someone else who is overly pessimistic. While there is the potential for correlated errors in judgment, they’re the exception, rather than the norm. By making the assessments of credit rating agencies part of the rules of the game, risk-weighting created a situation in which a very small set of actors — with none of their own resources on the line — were able to bias the judgment of the entire financial sector and create a massive misallocation of society’s resources.

Raising capital requirements and reducing the investments that banks are allowed to take will make our banking system marginally more reliable, but it will also discourage saving — not a good thing for an economy that has historically saved much less than is optimal. It would be better to tackle the problem directly and bring competition to the credit-rating game. We need a risk-weighting of our risk-weighting — rather than have the government rely upon just a few hand-picked credit rating agencies to inform its capital requirements, it needs to draw from a more diverse set and weight their various judgments according to past performance. It needs to aggressively use the Securities and Exchange Commission’s oversight to ensure competitiveness between rating agencies. And it should even consider forming a public credit rating agency, whose judgments would be included on equal footing with private agencies in the weighted set of credit ratings.

Reform of our financial regulatory system is needed. The Dodd-Frank bill of 2010 was an excellent start: it took the unclear or non-existent procedures for seizing and unwinding insolvent financial institutions and formalized them, ending the “too big to fail” problem that plagued our initial response to the financial crisis. But developing the tools to respond to bank failure is not the same as preventing the failure from the start — Title IX, Subtitle C of Dodd-Frank prevents outright collusion between credit rating agencies, but it does nothing to mitigate honest accidents in the rating process; the prospect of a common-cause failure of our financial system is just as potent as ever. And the proposals being put forward today to reduce the frequency of future events are throwing out the baby with the bathwater. Demanding higher capitalization is an inefficient half-measure; what we need today is a rethinking of capitalization itself.