To end the Too Big To Fail syndrome, require banks to have some serious amounts of capital

That is the core point of a new book, The Bankers’ New Clothes, reviewed by John H. Cochrane in the Wall Street Journal Running on Empty – Banks should raise more capital, carry less debt – and never need a bailout again.

Federal policy guarantees essentially all bank deposits. That creates moral hazard, which means banks can take extreme risks and depositors don’t care. The feds are on the hook for any failure, so why should bank management or depositors worry about risk levels? To mitigate risk, the regulators have thousands of pages of rules on the asset side of the balance sheet. Check this out:

The U.S. government has instead addressed the risks of banking crises by guaranteeing bank debt. Guaranteeing debts creates perverse incentives, so our government tries to regulate the banks from taking excessive risks:

Here is a great description of the leveraged risk.

Far more value was lost in the 2000 tech bust, for instance, than in the subprime mortgages that sparked the 2008 crisis, but the tech bust did not cause a financial crisis. Why? Tech companies were funded by stocks, not short-term debt. Worried shareholders can drive down the price of a stock, but they have no right to demand that the company redeem shares at yesterday’s price, so they can’t drive the company to bankruptcy in a run. Depositors and other short-term creditors have a fixed-value, first-come-first-serve promise from a bank—they can run.

I love that word picture of a stockholder not being able to demand stock redemption at yesterday’s price. That’s exactly what a bank depositor can do the day after everyone realizes the bank is in trouble.

Check out the review for lots more explanation of the serious risk factors that are still in place.

Oh, those really stiff 7% capital requirements in Basil III regs that will solve all our problems? Those rules look at the riskiness of assets and adjust the capital requirement accordingly.  The authors unwind those requirements and it works out to about 2% or 3% actual capital. So those huge increases in capital requirements are really no big deal.

The perverse incentives don’t seem to end.

When essentially all debt is guaranteed, the cost is artificially low, pushing banks towards debt from equity, which puts more pressure on risk. All that regulation requires more lobbying.

The level of crony capitalism involved makes politicians, regulators, bankers, and their lobbyists happy.

You can find the book at Amazon here. Check out the reviews. One commenter realized preventing the next banking crisis could be solved at no net cost to society.

Leave a Comment

Your email address will not be published. Required fields are marked *