ALBERT HERTER

‘THE MYSTERY OF CAPITAL,’ by James Kwak at baselinescenario .com.

In Uncategorized on May 22, 2010 at 13:53

The Mystery of Capital

Posted: 21 May 2010 09:05 AM PDT

By James Kwak

So the dust has settled on the Senate bill, and it remains studiously vague about capital requirements — no hard leverage cap, for example. This is what the administration wanted, for two reasons: first, they claim that regulators need ongoing flexibility to modify capital requirements; second, they claim that they need flexibility to negotiate a uniform international agreement.

There is one thing in there that is controversial enough to get the attention of the bank lobbyists: the Collins Amendment, which Mike Konczal has written about here. The main provision of the amendment is that whatever capital requirements apply to insured depositary institutions (banks), they also have to apply to systemically important financial institutions, including at the holding company level.

Sheila Bair of the FDIC is in favor of the amendment, on the argument that bank holding companies should not be able to evade capital requirements that are imposed on their subsidiary insured banks; she doesn’t want to regulate the depositary institutions but have all her work rendered irrelevant because the holding company collapses, triggering a mess of cross-guarantees.

This seems entirely unobjectionable, but as Konczal points out, the real threat to the banks is that it makes it harder for them to engage in financial engineering on the holding company level to evade capital requirements. According to the Wall Street Journal, not only the banks, but also the administration itself is planning to try to kill this amendment (at this point, in conference committee).

The administration’s argument, as mentioned above, is that these kinds of rules should be negotiated internationally, not set by Congress, which is overly political. But as Bloomberg pointed out earlier this week, international negotiations are nothing if not political. And as Konczal highlighted, the administration is also taking the banks’ side in the international arena.

The Collins Amendment wants to make basic capital requirements simpler, with the option of adding more complex requirements on top (“shall serve as a floor for any capital requirements the agency may require”). Opponents want regulators to have as much discretion as possible. I think it’s important to have a simple floor, because discretion and complexity are just a way of fooling ourselves into thinking we can measure something that is inherently unmeasurable.

A while back, Steve Randy Waldman weighed in on bank capital requirements. He goes much further and deeper than Simon and I did in our article about capital requirements. “Bank capital cannot be measured,” he says. His point is both practical and epistemological.

On the practical side, look at Lehman: it was well capitalized on paper right before it collapsed, and then a few days later it had negative equity of at least $20 billion. (And it wasn’t because of some fire sale, Waldman explains.)

Here’s the epistemological side (the part I like the most):

“Capital does not exist in the world. It is not accessible to the senses. When we claim a bank or any other firm has so much ‘capital’ we are modeling its assets and liabilities and contingent positions and coming up with a number. Unfortunately, there is not one uniquely ‘true’ model of bank capital. Even hewing to GAAP and all regulatory requirements, thousands of estimates and arbitrary choices must be made to compute the capital position of a modern bank. There is a broad, multidimensional ‘space’ of defensible models by which capital might be computed. When we ‘measure’ capital, we select a model and then compute. If we were to randomly select among potential models (even weighted by regulatory acceptability, so that a compliant model is much more likely than an iffy one), we would generate a probability distribution of capital values. That distribution would be very broad, so that for large, complex banks negative values would be moderately probable, as would the highly positive values that actually get reported. . . .  Given the heterogeneity of real-world arrangements, no ‘one-size-fits-all’ model can be legislated or regulated to ensure a consistent capital measure. We cannot have both free-form, ‘innovative’ banks and meaningful measures of regulatory capital.”

This is a point that I think is often lost. People talk about capital like levees to protect against a flood, but it’s like levees that you can’t see and measure, only guess at. Capital is probabilistic, so it’s only as dependable as your ability to assess those probabilities.

And, of course, with banks the errors always come out the same way — overstating capital:

“For a long-term shareholder of a large financial, optimistically shading the firm’s position increases both the earnings of the firm and the ‘option value’ of the firm in difficult times. It would be a massive failure of corporate governance if Jamie Dimon or Lloyd Blankfein did not fib a little to make their firms’ books seem a bit better than perhaps they are, within legal and regulatory tolerances.”

And here’s Waldman’s conclusion: “We need either to resimplify banks to make them amenable to the traditional approach, or come up with other approaches more capable of reigning in the brave new world of banking.”

Ultimately, capital requirements alone are not the answer. But as long as we’re going to base our banking regulation on them, we should make them as resistant to definition error and measurement error as possible.

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