Wednesday, October 14, 2009

The right capitalization ratio

A lot of people (i.e. media pundits and bloggers) have been publicly debating the issue of the "right" or "appropriate" level for capitalization ratios as it pertains to new regulations.

First, a brief background on the topic and why it is important:

Capitalization is also known as common equity, or the excess of assets over liabilities, and provides a buffer on losses arising from bad loans or trading positions. Larger amounts of capital reduces the risk of a bank becoming insolvent. In the run-up to this crisis, financial institutions "leveraged up," taking on more and more debt on top of their equity.

Below is a graph of major investment banks leverage ratios over the period 2003-2007, as you can see the trend is definitively positive.

This meant that less capital was available to cover losses if positions were to sour. Chasing ever-higher earnings estimates drove IBers to take on enormous amounts of risk. But as we've witnessed in this crisis, central banks are unwilling (with notable exceptions) to let large and complex banks fail because their bankruptcy would create undue hardships on the financial system. And so the risks that should have been born by the employees and shareholders of these banks have instead been born by taxpayers (not just the US). So as the world economy appears to be coming out of the depths of a severe recession the discussion seems to be turning from what needs to be done to fix the current crisis to what needs to be done to prevent the next one.

Now, the discussion on the "right level" of capitalization rates:
It seems doubtful to me that any absolute level or even simply-calculated relative rate, I've heard 15% of tier 1 capital been thrown around, would be the most efficient form of regulation. A better plan would revolve around Basel II which has been implemented in New Zealand [a review of this can be found here].

My idea would say let the people who know best decide what capitalization rate works best for their specific business model. This idea requires rolling an incorporated bank back into a pseudo-proprietorship where the highest executives (who make the biggest business decisions): directors, CEO, and CFO would be required to take on sizable, personal liability for the business actions that they undertake. If Dick Fuld had to stake 100% of his net worth in Lehman Brothers (I know he lost a considerable amount, but he is still very well off), do you think his actions concerning leverage and MBS's would have been the same? I don't.

I don't think regulatory action of compensation practices is the way to reign in risk-taking in the financial sector. Introducing personal liability into the fold may bring down the risk of our great lending institutions.

Make the players get a little skin in the game and see how it turns the play around.


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