Bank Regulation Follies

The latest fad in bank regulation folly is to assert that much higher capital levels are the solution to the problem that was supposedly solved by Dodd-Frank. Amar Bhide provides a nice rejoinder to the fantasy that all we have to do is make banks hold more capital:

Yet focusing mainly on how much banks borrow while ignoring other, more serious recklessness is a bad regulatory bet.

Bank regulation, like lending, was once decentralized and judgment-based. Regulators relied mainly on examination of individual loans rather than capital-to-asset ratios. A typical bank exam would include scrutiny of every single business loan and a large proportion of consumer loans. Capital adequacy was a matter of judgment: examiners would figure out how large a buffer a bank ought to have, taking into account its specific risks.

Regulators then shifted to edicts requiring banks to maintain a specified capital cushion, thick enough to cover potential losses. This approach presupposes that bank assets and exposures can be accurately measured. In fact, the financial statements of mega-banks are impenetrable works of fiction or wishful thinking.

The problem goes beyond deliberate obfuscation. J.P. Morgan and Deutsche Bank have paid substantial sums to settle charges ranging from bribery to illegal foreclosures to abetting tax evasion. Ruling out the connivance of top executives raises an alarming question: Does Jamie Dimon, J.P. Morgan’s highly regarded CEO, have as little grasp of the exposures embedded in his bank’s nearly $80 billion derivatives book as Tony Hayward, the hapless ex-CEO of BP, had of the hazards of his company’s ill-fated rig in the Gulf of Mexico?

Indeed, ignorance about what is actually at risk makes debates about the right formula for capital buffers surreal. Moreover, the use of mechanistic rules to determine capital adequacy has also inadvertently encouraged systemic imprudence.

Nothing of course is going to change. The fix has been in from the get go. There is just too much money involved not to buy the requisite protection and plenty of multimillion dollar jobs await those who play ball.

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