Capital regulations said to fuel 2007-08 crisis

German economist Martin Hellwig says faulty capital regulations played a key role in the financial crisis of 2007-08 and recent proposals to improve them, by international banking regulators in Basel, Switzerland, fall far short of the reform needed.

He recommends two changes:

– We should get away from the principle that regulatory capital must be finely attuned to the risks that banks are taking.
– We should aim for substantially higher regulatory capital, well above ten percent and perhaps even closer to the twenty or thirty percent that were common before banks got used to the idea that the taxpayer couldn’t afford to let them fail.

Hellwig says at the core of the crisis were banks that were funding long-term loans with too much short-term debt. This came about because of:

(1) the shadow banking system, which Hellwig describes as “institutions outside the domain of banking regulation that financed themselves by issuing short-term debt in wholesale markets and that invested in tradable assets with longer maturities,” and

(2) capital requirements that were too low because they were tied to the perceived risk of the banks’ activities, which banks and regulators don’t know how to gauge.

Hellwig says risk-based capital requirements have made banks more susecptible to systemic risk, in two ways:

First, by encouraging banks to engage in derivative transactions as a way of getting risks, if not out of their books, at least out of their models, the model-based approach has contributed to enhancing the interconnectivity of the system. There is thus more room for domino effects than there used to be. The fate of AIG is a case in point.

Second, because, under the model-based approach, capital requirements for market risks tend to be lower than capital requirements for credit risks, this approach has encouraged banks to put as many assets as possible into their trading books rather than their credit books. They were thus more vulnerable to book losses arising from changes in asset prices arising from market malfunctioning and/or other institutions’ deleveraging.

 Capital is bank jargon for equity, which is the money that owners themselves have invested in a company, as opposed to money they’ve borrowed. Companies usually get equity by selling stock or making profits. Bank regulators set capital ratios, which tell how much of a bank’s operating money can come from borrowing and how much has to come from capital. This establishes how much of the owners’ own money will be used to cover unexpected losses on loans and investments. It sets the owners’ skin in the game and the bank’s capacity to survive a run by its lenders.