Capital Ideas

Can banks use a "capital insurance" scheme to dampen future crises?

Reeling from billions of dollars of loan losses, banks have started to sell assets and rein in lending to keep their capital from eroding. This may be individually rational, but collectively it is imposing a vicious cycle of tightening credit, weakening growth, and further loan losses on the world economy. Small wonder that, once they get through this mess, many central bankers want to raise capital requirements—at least during good times. Had banks been forced to hold more capital, the boom might have been more constrained, and there would be less of a bust.

This sounds sensible. It may also be deeply flawed, according to a provocative new paper presented at the Federal Reserve Bank of Kansas City’s annual economic conference in Jackson Hole, Wyoming. Compelling banks to hold more capital—typically, equity—goes against shareholders’ interests, because it results in a lower return on equity. This ultimately hurts economic growth because capital is diverted from projects that might have higher returns. In addition, worthy borrowers are denied loans. It may also be counterproductive, by encouraging banks to game the system.

So what is the solution? The novel proposal of the authors, Anil Kashyap and Raghuram Rajan, of the University of Chicago, and Jeremy Stein of Harvard University, is “capital insurance”: push banks to buy policies in normal times that deliver an infusion of fresh equity during crises. The proposal was the buzz among the assembled central bankers as they focused on how to deal with the next cycle.

Until the 1970s, memories of the Depression meant banks put a higher priority on capital than they did on growth. Then Walter Wriston, head of what later became Citigroup, revolutionised the industry by arguing that capital was often wasted. “The only reason we keep any capital is some of the old fogeys on my board insist that we do,” Mr Wriston told Paul Volcker, then president of the New York Fed, in the 1970s, Mr Volcker recalls.

Citi led the big banks into a new era of growth and diversification. But their emphasis on growth frequently led them to lend excessively, as they did to Latin America, resulting in massive write-downs and periodic financial crises.

Regulators responded in 1988 with the Basel Capital Accord which imposed uniform capital requirements on the world’s banks. But banks have always sought ways around the rules. Their use of off-balance-sheet vehicles to hold securitised mortgage paper in the last decade was largely driven by the fact that they required little or no capital. When lenders last year refused to refinance the short-term paper that funded the vehicles, banks had to take the assets onto their balance sheets, straining their capital ratios. “Since the business of banking is to take on and manage risk, any broad-based attempt to thwart risk-taking is likely to see it reappear in less transparent forms,” Mr Rajan told the conference.

The authors conclude that it is difficult to wean banks from leverage. Indeed, they question whether regulators should even try. Limited capital leads to good governance, they say. Supply bankers with too much equity and they will waste it on inefficient projects. Force them to rely on short-term debt, they say (rather overlooking evidence from the current crisis), and they will lend carefully lest wary investors yank their funds.

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