Thursday, March 05, 2009

Regulations killing the institutions they were meant to protect

yet again:
Economists now realize that reserve requirements, designed to make banks more LIQUID, have the unintended reverse impact during a panic, tying up cash that banks need to pay out in order to stem the panic. As a result, reserve requirements are fast disappearing as a tool of bank regulation. Similarly, capital requirements, designed to make banks more SOLVENT, also have the reverse impact during a crisis.
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Mark-to-market was adopted by regulators as the basis for determining minimum capital requirements. Creating an inflexible regulation based on an inherently volatile measure was always an accident waiting to happen.
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only the rates and benefits offered by a bank matter to a customer, not the reliability of the bank, thanks to the FDIC.
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Prior to government deposit insurance, U.S. banks voluntarily maintained capital-asset ratios in the neighborhood of 10 to 20 percent, way above current mandated levels.
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With banks thus always seeking to keep only the minimum required capital, the problem was further exacerbated by the Basel capital requirement formula, which requires less than half the capital if kept in the form of AAA securities compared to high quality individual mortgages (as I discuss in my article on Credit Default Swaps, forthcoming in the April 2009 issue of THE FREEMAN). This caused an explosive increase in the worldwide demand for AAA securities as a result of the needs of regulatory arbitrage.
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With capital of virtually every international bank invested as heavily as possible in AAA securities critical to the financial competitiveness of the bank, the problem was further exacerbated by the ratings cartel created by the SEC in 1975, which effectively mandated that companies obtain a rating from Moody's, S&P, or Fitch, who were thus effectively insulated from the destructive effects of reputational damage by a system that made it impossible for them to be put out of business by more accurate upstart rating services. This also prevented better methods of risk measurement (such as Credit Default Swaps) from replacing ratings.

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