Bank capital requirements and risk

The basic business model of a bank is to use
other people’s money (deposits) to make loans.
There could be a problem if banks don’t care
about the riskiness of their loans because
it is not their own money at risk. When
depositors are insured they don’t care about
the risk either, so this presents a potentially
dangerous situation. The deposit insurance
agency has incentive to care about the risk,
but it might be hard for them to adequately
monitor this.

As a result of this, banks are required to
make sure some of their own money is at
risk. Banks are required to hold an
amount of equity (also called capital)
equal to a percentage of their assets.

(The basic accounting equation is:
equity = assets – liabilities

For a bank, assets are mostly loans, and liabilities
are mostly deposits.

The Savings and Loan crisis of the late 1980s shows
the danger of banks with too little capital.
However, the problem with a capital requirement
based on a percentage of asset value is that it is necessary
to determine the value of the assets. If a bank
is in trouble because of bad loans, then its
total asset value is shrinking. It is hard
to objectively determine the value of a loan that
might or might not be paid back. If banks are allowed
to overvalue their loans then that means they are
undercapitalized.

Regulatory capital requirements contributed to making
the financial crisis worse by making capital requirements
depend on the perceived riskiness of the assets. It sort
of makes sense to require banks to hold more capital
when they hold riskier assets, except that doesn’t work
if you can’t objectively assess the risk. The 2008 financial
crisis was worse because regulators under-valued the risk
of mortgage-backed securities, so banks had an incentive
to hold more of those securities because that lowered their
capital requirements. One example of how this works is at

https://www.fdic.gov/news/news/financial/2012/fil12027.html

There must be a better way to set up bank capital requirements.
to be continued…
click here for part 2

……………..
–Douglas Downing
You are welcome to write your comments on the facebook page at

https://www.facebook.com/DouglasADowningSPU/?ref=profile
This blog is part of the

Seattle Pacific University Political Economy blog group.
New items will be posted about three times per week.