BANKS AND BANKING : MORE CAPITAL WILL NOT STOP THE NEXT CRISIS / THE FINANCIAL TIMES COMMENTARY & ANALYSIS ( RECOMMENDED READING )

More capital will not stop the next crisis

By Raghuram Rajan

Published: October 1 2009 22:37

The Group of 20 wants banks to have more capital. As one element of a broad range of regulatory reforms, this is unexceptionable. However, if it is to be the main reform, with others playing only supporting roles, we should worry.

A number of banks went directly from being well capitalised to default. Part of the problem lies with the accounting, which allows banks to hide a variety of losses, and part with the regulatory incentive to delay recognising losses. But the bulk of the problem lies with the sheer magnitude of the losses in a systemic crisis such as the current one. The levels of capital required to protect banks fully from failure would be extraordinary.

Capital is costly. In good times the market demands very low levels of it from financial intermediaries, in part because euphoria makes losses seem remote. So when regulated financial groups are forced to hold more costly capital than the market requires, they have an incentive to shift activity to unregulated areas – as banks did in setting up structured investment vehicles. More alert regulators could perhaps detect and prevent this, but banks could subvert capital requirements by taking on balance-sheet risk the regulators do not see, or do not penalise adequately with capital requirements. Banks will not be passive in the face of regulatory change.

Such arbitrage is one reason excessively high capital requirements are unlikely to hurt financing much in America. Also, the US’s vibrant corporate bond markets can substitute somewhat for over-regulated banks. However, in emerging markets, where banks are the main source of finance, and arbitrage possibilities more limited, capital requirements set too high will reduce intermediation substantially. Emerging markets need to be cautious about accepting significant increases in capital requirements.

Better alternatives are to have more uniformity in capital requirements across leveraged financial institutions, to require more “contingent capital”, and to emphasise capital raising as well as preservation when regulators see a crisis coming. Let me elaborate.

First, all financial institutions operating with substantial short-term leverage – including hedge funds – should have to meet minimum capital and maximum leverage ratio requirements. While this could vary a little based on activity, the variation should not be so large as to induce arbitrage.

Second, more emphasis should be placed on “contingent capital” infused when the institution or system is in trouble. Because these arrangements will be set up in good times, they will be cheap (compared with raising capital in a recession) and easier to enforce. Also, because the infusion is seen as unlikely, institutions cannot increase risk using the future capital as backing. Finally, infusions come in bad times when capital is really needed, and so protect the system and taxpayer in the right contingencies.

One version of contingent capital devised by the Squam Lake Group* is for banks to issue debt that would automatically convert to equity (with the number of shares the debt converts into set so as to dilute the value of old equity substantially) when two conditions are met: first, the system is in crisis, based on objective indicators such as aggregate bank losses; and second, the bank’s capital ratio falls below a certain value. The first condition ensures banks that do badly because of their mistakes, and not because of a downturn, face the disciplinary effects of debt. The second allows well-capitalised banks to avoid the dilutive effect of the forced conversion, while encouraging banks that anticipate losses to raise new equity in good time, protecting taxpayers.

Finally, early regulatory action can be a source of timely capital. In anticipation of, or during, a crisis, regulators must be much firmer about banning bank dividend payments, requiring stock issuances and demanding compensation beyond a certain level to be paid in bank stock (without offsetting stock buybacks), perhaps mandating these actions across the system. Banks will oppose these actions. Such powers will require careful judgment, but they are worth acquiring.

The minimum hurdle that reforms should meet is whether they would have prevented the last crisis. Any feasible level of required capital would not cross this hurdle, so let us not rely too much on it to avert the next crisis.

*www.cfr.org/publication/19002

The writer is a professor of finance at the Booth School of Business at the University of Chicago

Copyright The Financial Times Limited 2009.