FinReg's killer app
"Capital requirements" are one of those terms that wonks are suddenly using a lot and that plenty of people are probably still confused by. But they're important to understand, because they're the killer app of financial regulation. David Leonhardt offers an exceptionally clear explanation:
One good way to understand the importance of capital is to look at the fate of firms that entered the crisis with relatively thick cushions. In 2007, commercial banks had an average leverage ratio of about 12 to 1, according to a recent report by McKinsey & Company. This means the banks had a dollar in assets for every $12 in debt. That was enough for many of them, like Bank of New York, to survive the bust in decent shape. In Canada, financial firms had an average ratio of about 18 to 1, and Canada endured the crisis better than perhaps any other rich country.
By contrast, the five big investment banks in this country — Bear Stearns, Goldman Sachs, Lehman, Merrill Lynch and Morgan Stanley — were close to or exceeding a ratio of 30 to 1. Of the five investment banks, Lehman collapsed, Bear and Merrill were sold at cut-rate prices and Goldman and Morgan Stanley might not have survived without government aid.
The crisis has made Wall Street much more conservative. But this will not last. It never does. Left to their own devices, financial firms will again take on big debts and big risks. They have a lot of incentive to do so. A Wall Street Journal analysis found that if one set of stricter leverage standards had been in place during the five years before the crisis, it would have reduced the biggest firms’ profitability by almost 25 percent.
Capital requirements do three things: First, they limit the amount of risk-taking that large banks can do, as they have less money to play around with. Second, they make it likelier that if the banks do take risks that go bad, they have enough money to bail themselves out. Third, they hold down the size of the bank (and its interconnectedness): A firm with billions in assets that are leveraged at 18 to 1 is of less importance to both the economy and to other banks than that same firm leveraged at 50 to 1, as the firm at 50 to 1 is both bigger and borrowing a ton of money from other banks, so their failure represents a bigger threat to both the economy and the other players in the financial system.
March 29, 2010; 11:00 AM ET
Categories: Financial Regulation
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