Streetwise Professor

August 16, 2010

Capital, My Boy. Or, A Triumph of Hope Over Experience

Filed under: Economics,Financial crisis,Politics — The Professor @ 7:01 pm

A good deal of my summer reading has been focused on books about the financial crisis.  The more that I read, the more that I am convinced that capital rules were a major contributor to it.  Not a sufficient condition, but a condition of first order importance.  A good chunk of the problematic securitization, subprime, SIVs, the lot, was a direct response to capital rules and the efforts of banks to minimize the amount of capital that they had to hold.  “Optimizing” structures with respect to the ratings and the capital rules allowed leveraging of subprime securities to 50:1 or better.   Moreover, since all major institutions faced the same incentives, the capital rules encouraged them to crowd the same trades, greatly exacerbating the systemic effects of the real estate meltdown.

The capital rules are also heavily implicated in other problems in the news recently, e.g., the sovereign debt problems at many European banks.

Which is why I shudder whenever I hear capital requirements ritually invoked as a crucial component of policies intended to prevent the next crisis.  Talk about your triumphs of hope over experience.

My trepidation was heightened even further when I read the excellent Deus ex Macchiato this morning:

Basel III, as one might expect for something written in an awful hurry and without the luxury of much impact analysis, will make this situation worse. It adopts the same approach to regulatory capital as I apply to wrapping parcels: keep on adding things piecemeal until it looks bulky enough to survive. I can go through half a roll of tape for a big parcel, and the result is always ugly. Sadly the consequences of adding extra lumps of capital here and there are equally ugly but less likely to result in safety: they could well result in risk leaving the banking system, and/or banks optimising the channels of their risk taking. The fact that these consequences are not obvious to the Basel Committee is deeply dispiriting. It isn’t quite too late to fix these problems, but with the full Accord due in October, the clock is ticking…

Dispiriting indeed.  I have seen this movie before.  I don’t want to watch it again, but feel that I am–we are–fated to.

Great.

PS.  Feel better, David.  I had a virus that kicked my backside a couple of weeks ago, so I can relate.

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6 Comments »

  1. […] This post was mentioned on Twitter by Craig pirrong, Craig pirrong. Craig pirrong said: Updated my SWP blog post: Capital, My Boy. Capital. ( https://streetwiseprofessor.com/?p=4192 ) […]

    Pingback by Tweets that mention Streetwise Professor » Capital, My Boy. Or, A Triumph of Hope Over Experience -- Topsy.com — August 16, 2010 @ 7:18 pm

  2. Thank you… I’m slowly getting better.

    I like your point about crowding – that angle has not been much explored, but I think that it is important. It suggests that there is a significant argument for regulatory diversity, in that at least different bad rules lead to different arbs. If we don’t believe that good rules can be agreed (which, dispiritingly, is probably true), then we should perhaps encourage lots of different sets of bad ones.

    Comment by David — August 19, 2010 @ 1:41 am

  3. […] Streetwise Professor points out something that I had not realised about regulatory capital arbitrage: not only do regulatory capital […]

    Pingback by Deus Ex Macchiato » Crowded trades in capital arb — August 20, 2010 @ 12:09 am

  4. […] August 20, 2010 Filed under: Brief Comments | Tags: Bailouts, Central Banking, Regulation | Craig Pirrong and David at Deus ex Macchiato are worried that the minimum capital requirements set by Basel III […]

    Pingback by Basel III and bank capital for the long-run « Synthetic Assets — August 20, 2010 @ 4:32 pm

  5. […] everybody is so impressed with my argument.  Synthetic Assets, for example: Craig Pirrong and David at Deus ex Macchiato are worried that the minimum capital requirements set by Basel III […]

    Pingback by Streetwise Professor » Basel Faulty — August 28, 2010 @ 9:55 pm

  6. […] Craig Pirrong and David at Deus ex Macchiato are worried that the minimum capital requirements set by Basel III will face the same problems as those created by earlier versions of Basel:  As banks seek to minimize their capital positions they are all pushed by the regulations into the same trades, this leads to the growth of unregulated financial sectors and crowded trades. […]

    Pingback by Basel III and bank capital for the long-run — Clearing and Settlement — October 5, 2011 @ 4:47 am

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