Wednesday, July 01, 2009

Will more capital harm banks?

Regulators are determined to impose higher capital requirements for banks in the wake of the present crisis. The rationale to is to make sure that banks are less vulnerable in future than they have proved this time.

Takafumi Sato, commissioner of Japan's Financial Services Agency, questions this approach in an article in the FT:

Suppose stronger regulations make banks issue more equity. Then the capital market will expect greater profits in return, and bank management may be tempted to meet such profit pressure by taking more risks. Was this, however, not the cause of the catastrophe?

Also, bigger capital requirements may induce complex risk-taking. If bankers add simple risks, regulators will notice and request more capital. In order to satisfy both regulators’ demand for a high capital-to-risk ratio and investors’ demand for return on equity, bankers may want to take risks in a sophisticated manner, inventing exotic products and creating a darker shadow banking system.

So, Sato thinks there is moral hazard attaching to more bank capital rather than less. Sato's argument is flawed on several counts:
  • With lower bank capital, equity holders today have less incentive to monitor managers.With higher capital, they will need to be more alert.
  • Also, managers have greater incentive to take risks- payoffs to risky gambles are higher with lower capital and more debt.
  • It's not as if investors' return expectations from banks are cast in stone and they will demand the same returns from banks as they have in the past even when bank capital goes up. Investors in banks will have reconcile themselves to lower returns, treating bank stock on the same par as, say, utilities. As they say, banking will become a more boring sector but a safer one.
Sato is on firmer ground when he writes:
Capital adequacy regulations are a cornerstone in our efforts towards financial stability. They, however, should be complemented by reliable valuation, good risk measurement and proper incentives.
On this, I agree. Higher capital should be accompanied by closer supervision and regulation. Isn't that what all the talk of regulatory reform is all about?


Shrini said...

Hi Ram,
I have been an avid follower of your blogs. They are really excellent. I came across an article

Can you throw some light on this post


K.R.Srivarahan said...

A few years back, the then Bharat Overseas Bank Ltd.,a private sector bank owned by seven banks was about to come up with an IPO. At that time, a study was conducted which showed that PE Ratio of a bank's share and the bank's capital adequacy ratio were positively correlated. This shows that the market ("wisdom of the crowd") perhaps respects strength arising from capital and does not greedily expect higher profitability from enhanced capital.The argument that higher capital per se attracts higher risk is fallacious.

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