Wednesday, March 3, 2010

Regulatory capital and who’s got the money?

Regulatory Capital

Increased capital is ultimately the solution. But, timing changes is probably more important than the level. What we know about reserves is that people lower them in good times and raise them in bad times. We also know this aggravates the cycle. Well, surprise, surprise, governments are people; they do the same thing. Unfortunately, the government has a long history of changing capital requirements in the wrong direction over the business cycle. It’s the fallacy of composition writ large. Individual banks are safer with higher reserves, but if every bank raises more capital, oops, no credit even for productive endeavors.

Basel 2 was supposed to address the reserve issue, but we should be skeptical. The risk models used for Basel 2 didn’t do so well at avoiding the mess we were in last year. There is no reason to believe they would protect us from the mess we’re making now. (A technical side note: if a Markov process is representative of the functioning of financial markets, then even replacing the assumption of normal distribution with realistic probability distributions will not result in risk models that would justify regulators’ faith in Basil 2. Further, without better understanding and modeling of structural characteristics that create risks of common mode, and especially cascade failures, even Monte Carlo simulations won’t yield reliable probability distributions).

Perhaps something could be done through margin requirements that apply to more types of assets. Historically, since WWII, we have done better with them, mainly because they haven’t been changed very often. Margin requirements are a subtle way to adjust capital requirements. If we could believe the government would raise margin requirements for bond positions, we might legitimately feel more comfortable. But, their history with Fannie and Freddie bonds is just the opposite. They subsidized them with an implicit loan guarantee, placed them high in banks’ capital structures, and lowered the capital requirements of Fannie and Freddie. Margin requirements as a response to systemic risk also raises the ugly issue of what type of collateral is appropriate for government bonds.

There is generally a flaw in the thinking about capital and banking. The flaw is a focus on the wrong type of risk if systemic risk is the issue. The focus is on event risk rather than common mode failure and cascade failure. The collapse of any institution is an event. But systemic risk generally doesn’t arise from the collection of events. It arises in one of two ways. One way is a common mode failure where one common factor causes a grouping of events above some critical level that justifies calling it systemic (i.e., makes it a system problem). The other is that one event triggers another until either an event of great consequence or a total of all the events justify calling it systemic. But, a cascade failure doesn’t have to start with a large institution, or even a noticeable event. Think of the butterfly effect.

Once the focus shifts from event risk to common mode and cascade failures, it calls into questions a lot of assumptions about regulatory capital. The thorniest issue is who should “hold” the capital. If the failure is common mode, then more capital at the organizations subjected to the common risk isn’t very efficient and will probably fail. Similarly, if it’s a cascade failure, the circuit breaker has to come from outside the chain reaction causing the breakdown. So, while capital requirements are important, they’re neither a quick fix nor an assured solution.

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