Would Increased Capital Requirements Stabilize the Banks in Europe?

|Peter Boettke|

Simon Johnson argues that the Bassel III negotiations from last year resulted in lower capital requirements which was folly, and now exposes the European banks to great risk.  What do you think?

Along these lines, at the recent HES meetings I had the occasion to speak with Perry Mehrling, the author of The New Lombard Street (among many other works, e.g., his excellent biography on Fischer Black).  Perry argues that free market types like myself ask the wrong question when we focus on letting the banks fail and thinking about decoupling the links that cause counter-party contagion.  At a fundamental level, he argues the international credit system is not characterized by counter-parties, but by an intricate interwoven web of interlocked balance sheets.  You cannot decouple, and thus a bank failure here results in a crash over there.  My response, for sake of argument, was that this resulted in an extremely fragile international financial system, and thus I asked the question back to him --- how do we make the system more robust?  And especially given the system and the politics involved, how would we ever overcome the permanent moral hazard the system as he describes it creates?  I didn't get a concrete answer.  

Though at some level this is what Nassim Taleb is asking as well, also see him discuss this idea:

 

Comments

[Ashwin]

Higher capital requirements may help but Taleb is right - ultimately there is no substitute for allowing failure, especially early failure.

It is well-established that in complex adaptive systems, we need to allow "natural" small disturbances to play themselves out. If we attempt to protect players against all disturbances, we make the system increasingly fragile and the inevitable eventual failure is catastrophic. There are many examples in ecology but the best comparison is to forest fires - the long policy of suppressing all fires from 1910 to the late 70s in the United States has led to a dramatic increase in the severity of fires since.

Taleb mentions Greenspan and Bernanke but this policy of stabilisation has been followed since atleast the Penn Central Railroad bankruptcy in 1970 as Minsky highlighted. I wrote a long post a few weeks ago comparing the theory and the history of forest fire suppression and macroeconomic stabilisation in the United States here http://www.macroresilience.com/2011/06/08/forest-fire-suppression-and-macroeconomic-stabilisation/ .

[Jerry O'Driscoll]

Before federal deposit insurance and other bank safety nets, bank capital used to be in the range of 20-25%. Large banks view taxpayer funds as their backstop and, in truth, would prefer to hold no capital.

Bank profitability would fall in the short run if capital requirements were raised. But those profits are the fruit of taxpayer guarantees. They are economic rents that properly belong to taxpayers, not stockholders.

So, yes rise capital requirements, scale back guarantees, etc. Then the network will unwind itself. On guarantees, a good place to start would be to rpeeal section 13(3) of the Federal Reserve Act (the emergency lending provision).

The Swiss have effectively abandoned Basel (some irony there). Capital requirements for the largest Swiss banks are now 19%.

[Richard Ebeling]

Besides capital requirements and no "too big to fail" expectations, under the current central bank managed banking system, I wonder if there is not some reasonable truth to the benefit of one hundred percent reserves.

That is, if demand and related deposits were, in fact, "warehouse" accounts, and all time and other longer-term deposits were not open to immediate withdrawal on demand (or only with significant penalty), it would seem to be far more difficult for many of these financial problems to emerge in the way that they have.

If this involves less flexibility, or market "creative" adaptability, so be it. If it initially lowers banking profitability (as Jerry, above, suggests about larger capital requirements), so be it.

The task -- in a world without free banking -- is to try to make the system more stable, sustainable, and business cycle 'free," and without heavy-handed government micro-managing regulation, control, and government-business manipulating corruption.

Richard Ebeling

[Barkley Rosser]

A correction. Simon did not say that Basel III led to "lower" bank capital requirements, but that the Europeans favored "low" ones. They were raised, and indeed the Basel Committee has just demanded an increase from 7% to 9.5% for the "too big too fail" banks, with who they are being a matter of some contention (and some being named claiming that they are not).

This is of course relevant to the remarks of both Ashwin and Perry Mehrling as well as Taleb. The system is deeply interconnected and fragile, as we saw, but we need to allow as much ability to fail as possible. The problem is precisely this "too big to fail" stuff, with failures of those being like the catastrophic forest fires. How to avoid them without having this plague of moral hazard. No easy way out, and Hyman Minsky is chuckling in his grave.

[Barkley Rosser]

BTW, my next book due out within the next couple of weeks has a discussion of this forest fire example, along with a lot of other related stuff. It will be out from Springer and is entitled _Complex Evolutionary Dynamics in Urban-Regional and Ecologic-Economic Systems: Beyond Catastrophe and Chaos.

[Jerry O'Driscoll]

I commend the speech by Kansas City Fed President Tom Hoenig on too big to fail. It's written up in Real Time Economics in today's WSJ.

Hoenig raises the issue of shadow banking, and its extensive use of short-term financing for long-term investments. It is the same issue that Richard is raising for commercial banks.

[Ashwin]

As Barkley said, Minsky foresaw all of this. I recently re-read his book 'John Maynard Keynes' which he wrote in 1975 and it is genuinely shocking just how accurate his diagnosis of our financial system was. I've just copied below a section from the concluding chapter:

"The success of a high-private-investment strategy depends upon the continued growth of relative needs to validate private investment. It also requires that policy be directed to maintain and increase the quasi-rents earned by capital - i.e.,rentier and entrepreneurial income. But such high and increasing quasi-rents are particularly conducive to speculation, especially as these profits are presumably guaranteed by policy. The result is experimentation with liability structures that not only hypothecate increasing proportions of cash receipts but that also depend upon continuous refinancing of asset positions. A high-investment, high-profit strategy for full employment - even with the underpinning of an active fiscal policy and an aware Federal Reserve system - leads to an increasingly unstable financial system, and an increasingly unstable economic performance. Within a short span of time, the policy problem cycles among preventing a deep depression, getting a stagnant economy moving again, reining in an inflation, and offsetting a credit squeeze or crunch. Financial instability and business cycles, which were so evident historically, once again loom on the horizon. The apparent stability and robustness of the financial system of the 1950s and early 1960s can now be viewed as an accident of history, which was due to the financial residue of World War 2 following fast upon a great depression."

[Barkley Rosser]

BTW, there are some people out there trying to reconcile Minsky perspectives with Austrian ones, although I am not in a position to comment on that publicly at this time for reasons some may well understand...

[Jerry O'Driscoll]

There were many writers before Minsky making the same or similar points. Henry Simons comes to mind. He particularly focused on the peverse elasticity of short-term credit (his phrasing), and its use to fund long-term investments.

The classical economists wrote of waves of speculation driving manias. I'm inclined to credit Richard Cantillon as the first to offer a systematic anlysis.

"Nothing is new except what has been forgotten."

[Barkley Rosser]

Cantillon is a case of "it takes one to know one," as he made money out of both the Mississippi and South Sea bubbles of 1719-20, only then to push a strong monetarism to forestall such shenanigans. In the case of the Mississippi bubble, he was on a boat to England when his last deal was consummated, a shorting by his bank of the bubble.

[Jerry O'Driscoll]

Yes, and Cantillon also was one of the few economists to be murdered. Bruno Leoni was another.

[Mathieu Bédard]

I'm not sure I understand the distinction between counterparty driven contagion and "an intricate interwoven web of interlocked balance sheets" (if there really is one), but empirical litterature largely does not confirm the existence of a direct "knock-on" contagion. And case studies of past Too Big To Fail failures have shown that barely no banks have failed due to the direct losses. The litterature seems to confirm that contagion is informational and acts through the reassesment of bank's exposure to risk following a default/bankruptcy. The "liquidity spiral" describes what happens at an operational level.

I'm surprised by the overwhelming "yes, raise the capital requirements" of other commenters. Is there no merit in Rochet 1992 type of explanations where banks take riskier positions to offset higher capital requirements? What about the Friedman-Kraus point that capital requirements never plays the role of capital since banks can undergo FDIC resolution procedures if they ever are below their quotas? I'm under the impression that as long as there are the FDIC, the SIPC, etc. and their foreign equivalents there aren't really any way out of this...

[Current]

Regarding Richard Ebeling's thoughts on 100% reserves, I'm very sceptical about this.

There are two principle problems:
* Demand for money changes and there are large costs in not accomodating that change.
* Loans from deposits produce the income that banks rely on to provide free services. Without free services the benefits of bank balances are seriously reduced. That in turn will change the demand for money.

See my article criticising Toby Baxendale's proposal on the Cobden Centre site:
http://www.cobdencentre.org/2010/06/a-problem-with-the-baxendale-plan/