That’s the “what” and part of the “why.” But the current approach to bank capital and accounting is exacerbating the ups and downs. When times are good, loans and securities look less risky, and banks increase leverage to make more money without building capital. When times are bad, they do the opposite.
This is from March 2008, but David Wessel did a nice job of explaining succinctly why the mortgage losses had such a huge impact on the economy and markets. Then he moves on to discuss the obvious but not much discussed fact that the current bank capital requirements and accounting rules make the system pro-cyclical:
(…) “When asset prices rise, so does the value of collateral, which makes financing easier, increasing the demand for assets,” Jaime Caruana, then Spain’s central banker, observed in 2002. “That, in turn, pushes asset prices upward. In the downturn, as the value of collateral drops, financing possibilities decline, as does thus credit growth, a process often reinforced by financial institutions pursuing much more cautious credit policies as they are incurring losses or making smaller profits. … Tighter credit policies reinforce recessionary forces and provoke additional reductions in asset prices.”
For that reason, Spain, unusual among its peers, tweaked its rules in 2000 to require banks to set aside more capital when times are good so they have bigger cushions when times are bad.
The relatively new practice of requiring banks to value their loans and securities to market prices — instead of assuming, unless there’s good reason, the borrower will pay back the loan — pushes in the same direction. It was a well-intentioned response to the mistakes of the past when Japanese banks and U.S. savings-and-loans were allowed to lie about the true value of their loans and collateral for years.
But, as economist Hyun Song Shin of Princeton University noted at last week’s conference, when banks valued assets at what they paid for them, they had reason to sell when market prices rose and buy when market prices fell.
That welcome stabilizing effect has been lost. Banks today have incentives to buy more when prices are high, and are forced to sell when they are low.
As Mr. Shin and Tobias Adrian of the Federal Reserve Bank of New York wrote recently, “The expansion and contraction of balance sheets amplifies, rather than counteracts, the credit cycle.” Capital standards and mark-to-market rules add to euphoria in good times and despair in bad.
That isn’t smart.
Please continue reading…
We need at least a counter-cyclical scheme such a Spain which adjusts capital ratios. Also much more helpful than more complex regulation is a simple requirement for a minimum percentage of total capital in the form of subordinated debt (that becomes the canary indicating very sensitively if a bank is taking on too much risk).
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