Let borrowers assume more of the risk

Here’s an idea: Instead of requiring banks to have more capital, or equity, how about requiring borrowers to have more capital?

For example, instead of letting banks make 10-percent-down home loans, only allow them to make 20-percent-down home loans.  Instead of repo borrowers putting up collateral worth 105 percent of the repo loan, make them put up 120 percent.

The idea comes from Andrew Kahr, a principal in Credit Builders LLC, a financial product testing and development company. Kahr seems to have little faith that tougher capital requirements can prevent another crisis.

From his March 15 opinion piece in the American Banker:

To reduce anticipated bank failures to a tolerable level, we need either to increase capital or reduce risk.

It seems ironic that there have been very high-level, very detailed efforts to set rules that require much more capital: Basel III. Seeing this, one might imagine that prior tightening of capital requirements, Basel II, had produced providential or at least positive results. But it did not. We had the worst banking crisis since the 1930s — despite implementation of Basel II. Why?

Could it be that this happened because banks took progressively greater risks, outstripping the expanding protection provided by increased capital? Is it possible that they could do this again, with Basel III? Does more capital invite more risks? If so, risk-based capital, which requires more capital for some types of assets, can’t provide a solution.

The contrast with money market funds is stark. They have no capital at all. Their balance sheet and off-balance-sheet activities are tightly restricted. Yet there was only one significant failure among them: Reserve Fund. …

Instead of pouring more capital into banks, substitute the equity capital of would-be borrowers and counterparties for some of the debt capital recently provided to them by banks. We can call that risk retention, or alignment of interests, or avoidance of moral hazard.

Leaving aside assumption of credit risk by the government for social purposes, if residential total loan-to-value had been limited to 80 percent, we would be hearing much less about underwater homes — and resulting strategic defaults.

RepoWatch keeps an eye on capital requirements for banks because three of the seven steps that RepoWatch has identified as leading to the crisis of 2007 and 2008 were changes in how much capital, or equity, regulators said commercial and investment banks had to have to securitize.