Capital Ratios: Think of a Number and Double It

Do you have some free time this weekend? Here is something to read, if you can stand the excitement. The Financial Inquiry Commission has published its report. So far, I've only skimmed it, but it looks  thorough. It's a shame that the split between Democrats and Republicans on the panel will lessen, as I suspect, both its readership and its influence. The Republican dissenters could be right to say that report was insufficiently focused--when everything is important, as they say, nothing is--but I'm already wondering whether this disagreement has been overdone. (Fannie and Freddie, for instance, were a main bone of contention. Yet the majority report is pretty scathing, and agrees that political demands for more lending to poor borrowers to buy cheap houses played a part in what went wrong.) This Washington Post report gives a nice summary. I might have more to say next week.

No doubt my thinking on the new Basel bank-capital rules is still fresh in your mind.  You'll recall I said the new capital requirements were too low. I cited a terrific paper by Hanson, Kashyap and Stein which explains why. This new study by David Miles and others for the Bank of England comes to a similar conclusion, only more so.

We use empirical evidence on UK banks to assess costs;  we use data from shocks to incomes from a wide range of countries over a long period to assess risks to banks and how equity funding (or capital) protects against those risks.  We find that the amount of equity capital that is likely to be desirable for banks to hold is very much larger than banks have held in recent years and also higher than targets agreed under the Basel III framework.

Actually the capital ratio they come up with is 16 to 20 percent of risk adjusted assets, even if you ignore the most extreme low-probability events. This is more than twice as much as the new Basel ratios, let alone the old ones.

The bankers in Davos are apparently unimpressed.

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