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Capital Requirements Not Enough to Prevent ‘Too Big to Fail’

A recent column argued that existing public policy toward the “too big to fail” problem was based on an unrealistic premise: that capital requirements can be used to eliminate the risk of failure by systemically important companies, those whose failure would threaten the stability of the world financial system. This column explains why that premise is wrong.

A company’s capital is the value of its assets less the value of its liabilities. Insolvency occurs when asset values decline until they are smaller than liabilities, meaning that capital is negative.

The larger a company’s capital is at any time, the larger the shrinkage in asset values it can suffer before becoming insolvent. It seems intuitively obvious, therefore, that the way to make a systemically important company completely safe is to raise its capital requirements to the point where the company can withstand any shock to the value of its assets. But this view fails to account for the company’s reactions to higher requirements.

Private financial institutions will never voluntarily carry enough capital to cover the losses that would occur under a disaster scenario, such as the financial crisis in 2007-2008. For one thing, such disasters occur very infrequently, and as the period since the last occurrence gets longer, the natural tendency is to disregard it. In a study of international banking crises, Richard Herring and I called this “disaster myopia.”

Disaster myopia is reinforced by “herding.” Any one company that elects to play it safe will be less profitable than its peers, making its shareholders unhappy, and opening itself to a possible takeover.

Even when decision makers are prescient enough to know that a severe shock that will generate large losses is coming, it is not in their interest to hold the capital needed to meet those losses. Because they don’t know when the shock will occur, preparing for it would mean reduced earnings for the business and reduced personal income for themselves for what could be a very long period. Better to realize the higher income as long as possible, because if they stay within the law, it won’t be taken away from them if the company later becomes insolvent.

A capital requirement of, say, 6 percent means that a company will remain solvent in the face of a shock that reduces the value of its assets by 5.99 percent. How safe that is depends on the size of potential shocks that reduce the value of assets, which in turn depends on the riskiness of the assets the company holds. Systemically important companies can game the system by shifting into higher-yielding but riskier assets that are subject to larger potential shocks.

Regulators have tried to shut down this obvious escape valve by adopting risk-adjusted capital ratios, where required capital varies with the type of asset. Systemically important companies must hold more capital against commercial loans, for example, than against home loans, which are viewed as less risky. But this does not prevent the company from making adjustments within a given asset category. For example, during the years before the financial crisis, some mortgage lenders shifted into subprime home mortgage loans, which were subject to the same capital requirements as prime loans.

A given set of capital requirements may make systemically important companies safe in one economic environment, but not in another. In particular, if a bubble emerges in a major segment of the economy, as it did in the home mortgage market during 2003-2007, a massive shock to asset values will occur when the bubble bursts.

In principle, regulators can offset a shift toward riskier assets within given asset categories by breaking the categories down into even smaller subcategories subject to different capital requirements. And they can adjust to emerging bubbles by raising requirements for the sector being affected by the bubble. But such actions require a degree of intelligence, foresight and political courage on the part of regulators that history suggests we have no reason to expect.

Banks and other depositories have been subject to capital requirements since the 1980s. During the housing bubble, regulators did not set higher capital requirements for subprime mortgages, nor did they increase the ratios overall.

The need is for a regulatory system that can’t be gamed by these businesses; that does not require regulators to be smarter or more strongly motivated than the companies they regulate; and that, if a systemically important company nonetheless fails, imposes the cost of a bailout on all such companies rather than taxpayers.

Jack Guttentag is professor emeritus of finance at the Wharton School of the University of Pennsylvania. Comments and questions can be left at http://www.mtgprofessor.com.