Risk Management

Capital Ideas

Can banks use a "capital insurance" scheme to dampen future crises?
Economist StaffAugust 28, 2008

Reeling from billions of dollars of loan losses, banks have started to sell assets and rein in lending to keep their capital from eroding. This may be individually rational, but collectively it is imposing a vicious cycle of tightening credit, weakening growth, and further loan losses on the world economy. Small wonder that, once they get through this mess, many central bankers want to raise capital requirements—at least during good times. Had banks been forced to hold more capital, the boom might have been more constrained, and there would be less of a bust.

This sounds sensible. It may also be deeply flawed, according to a provocative new paper presented at the Federal Reserve Bank of Kansas City’s annual economic conference in Jackson Hole, Wyoming. Compelling banks to hold more capital—typically, equity—goes against shareholders’ interests, because it results in a lower return on equity. This ultimately hurts economic growth because capital is diverted from projects that might have higher returns. In addition, worthy borrowers are denied loans. It may also be counterproductive, by encouraging banks to game the system.

So what is the solution? The novel proposal of the authors, Anil Kashyap and Raghuram Rajan, of the University of Chicago, and Jeremy Stein of Harvard University, is “capital insurance”: push banks to buy policies in normal times that deliver an infusion of fresh equity during crises. The proposal was the buzz among the assembled central bankers as they focused on how to deal with the next cycle.

Until the 1970s, memories of the Depression meant banks put a higher priority on capital than they did on growth. Then Walter Wriston, head of what later became Citigroup, revolutionised the industry by arguing that capital was often wasted. “The only reason we keep any capital is some of the old fogeys on my board insist that we do,” Mr Wriston told Paul Volcker, then president of the New York Fed, in the 1970s, Mr Volcker recalls.

Citi led the big banks into a new era of growth and diversification. But their emphasis on growth frequently led them to lend excessively, as they did to Latin America, resulting in massive write-downs and periodic financial crises.

Regulators responded in 1988 with the Basel Capital Accord which imposed uniform capital requirements on the world’s banks. But banks have always sought ways around the rules. Their use of off-balance-sheet vehicles to hold securitised mortgage paper in the last decade was largely driven by the fact that they required little or no capital. When lenders last year refused to refinance the short-term paper that funded the vehicles, banks had to take the assets onto their balance sheets, straining their capital ratios. “Since the business of banking is to take on and manage risk, any broad-based attempt to thwart risk-taking is likely to see it reappear in less transparent forms,” Mr Rajan told the conference.

The authors conclude that it is difficult to wean banks from leverage. Indeed, they question whether regulators should even try. Limited capital leads to good governance, they say. Supply bankers with too much equity and they will waste it on inefficient projects. Force them to rely on short-term debt, they say (rather overlooking evidence from the current crisis), and they will lend carefully lest wary investors yank their funds.

Moreover, higher capital requirements may not prevent banks from tightening the screws on the economy during downturns. In America banks are rapidly tightening lending conditions even though their “tier-one” capital—mostly shareholders’ equity—stood at 10.1% of risk-weighted assets as of June 30th, well above the 6% that regulators consider “well capitalised”. Bankers are not hoarding capital because they have hit their minimums, says Mario Draghi, governor of the Bank of Italy. Rather, they are worried that markets will punish banks where the capital buffers slip.

Mr Draghi, like many regulators, argues that capital ratios should be tightened—perhaps mimicking Spain’s well-regarded system, where capital requirements rise during lending booms and fall during busts. But Messrs Kashyap, Rajan and Stein argue that since crises are rare, that will saddle banks with lots of wasted capital most of the time.

Putting aside money for a rainy day

Instead, they propose that banks be made to choose between higher capital requirements and buying capital insurance. A pension or sovereign-wealth fund would earn a premium and in return deposit, say, $10 billion of treasuries in a lockbox. When a predefined point is met, the funds would be released to the bank.

Numerous questions dog the proposal, among them who would define the trigger point, where to set it, and what countries and types of firms (besides banks) should participate. Alan Blinder, of Princeton University, noted that crises hurt almost everyone. Unless an insurer can be found who benefits from a crisis, “the insurance premium is going to be extremely high, because you’re making people pay in times when they don’t want to pay.”

Also, although the present system has hardly been perfect, it is not necessarily broken. True, it has encouraged risk-taking and short-term borrowing, and banks have allocated their resources neither efficiently nor wisely. Yet, for all the pain, no large bank has yet failed—thanks in large part to the capital they had been forced to hold. And banks have raised a remarkable amount of new capital, equivalent to almost two-thirds of cumulative write-offs so far, although this is getting harder.

Of course, the crisis is far from over. The conference fretted that with the financial shock now a year old, the real economy may still have not felt its full effect. It may yet be too early to overhaul today’s capital arrangements. But change looks inevitable and even unconventional ideas are guaranteed a hearing.