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Fictitious capital

from David Ruccio
The current bank reform bills are an embarrassment. Less than two years after Goldman Sachs and the other giant financial institutions sent the world economy to the edge of the abyss, Congress and the Obama administration have made no attempt to either cap the size of the banks or to create a wall between the real and shadow banking sectors. 

Everyone understands that, and so they’re hoping that at least some provisions might avoid or at least contain the next financial crisis. Like the Collins Amendment, which would increase capital requirements on the largest banks.

One problem is, bankers and government officials—including the Treasury and the Federal Reserve—are fighting tooth and nail against the amendment. 

The other problem is, capital can’t be measured. As Steve Waldman explains [ht: James Kwak], there’s a fundamental epistemological problem.

 When we claim a bank or any other firm has so much “capital” we are modeling its assets and liabilities and contingent positions and coming up with a number. Unfortunately, there is not one uniquely “true” model of bank capital. Even hewing to GAAP and all regulatory requirements, thousands of estimates and arbitrary choices must be made to compute the capital position of a modern bank. There is a broad, multidimensional “space” of defensible models by which capital might be computed. When we “measure” capital, we select a model and then compute. If we were to randomly select among potential models (even weighted by regulatory acceptability, so that a compliant model is much more likely than an iffy one), we would generate a probability distribution of capital values. That distribution would be very broad, so that for large, complex banks negative values would be moderately probable, as would the highly positive values that actually get reported. If we want to make capital measurable in any practical sense, we have to dramatically narrow the range of models, so that all compliant models produce values tightly clumped around the number we’ll call capital. But every customized derivative, nontraded asset, or unusual liability in a bank’s capital structure requires modeling. The interaction between a bank holding company and its subsidiaries requires multiple modeling choices, especially when those subsidiaries have crossholdings. A wide variety of contingent liabilities — of holding companies directly, of subsidiaries, of affiliated or spun-off entities like SIVs and securitizations — all require modeling choices. Given the heterogeneity of real-world arrangements, no “one-size-fits-all” model can be legislated or regulated to ensure a consistent capital measure. We cannot have both free-form, “innovative” banks and meaningful measures of regulatory capital. If we want to base a regulatory scheme on formal capital measures, we’ll need to circumscribe the structure and composition of banks so that they can only carry positions and relationships for which we have standard regulatory models. “Banks’ internal risk models” or “internal valuations of Level 3 assets” don’t cut it. They are gateways to regulatory postmodernism.

 A demonstration of Waldman’s “capital uncertainty hypothesis” is that Lehman was well capitalized, according to legal requirements, before it collapsed on 15 September 2008 and, days later, had a negative equity of at last $20 billion. 

Capital is uncertain. Therefore, hard capital and solvency requirements simply cannot prevent the next financial crisis.

  1. Peter Radford
    May 25, 2010 at 5:48 pm

    I couldn’t agree more. As an ex-banker I am well aware of the illusory nature of capital, which is, essentially, whatever you want it to be and is entirely contextual. But this isn’t news, bank asset and liability values can fluctuate enormously making the entire notion of a ‘fixed’, safe firewall called capital a far less useful notion in finance than elsewhere.

    There has been an awful amount of analysis and vexation since the crisis began, and having lived through at least two other major bank crises as an active participant I have a more jaundiced eye than most.

    Banking as a whole was well capitalized when the crisis began. What went wrong was not a paucity of capital but a complete failure of underwriting. Bankers forgot to be bankers. Instead they became deal makers. They gave up worrying about repayment and asset valuation because they tossed their assets into the market where, by some magic known only to folks like Black Scholes et al, rotten assets mysteriously turned into gold.

    A whole generation of bankers was brought up to believe the magic of markets. This was not some academic discussion in a distant graduate class, it was the active management of the capital flowing through the economy. People actually thought they had defeated risk. The math said so. The economic theorists said so. With risk mitigated all that was left was to churn assets quickly enough to generate profit and personal income.

    As I watched this taking place I was horrified at the forgotten lessons: I had spent a lot of my time in banking working to save banks broken by real estate mistakes. But what horrified me most was the slavish execution of what I thought was false economics, and the willful neglect of the diversity of thought some of which suggested that those risk models were simply wrong.

    My belief is that we won’t have stable banks until we have replaced the economics upon which the risk management techniques were built, and we have returned to the days when bankers worry how they will be repaid.

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