Tuesday, September 16, 2008

Is higher capital the answer in investment banking?

There is a sense that investment banks too will become subject to requirements of regulatory capital- at present, only commercial banks are subjected to the requirements imposed by Basel I (and hereafter Basel II). FT doesn't think this is a great idea:

There will now be renewed calls for more regulation, and understandably so. But it is naive to think that the right regulatory response is obvious. From poor governance to flawed incentives, incompetent risk management to foolish strategies, the failures of the financial system have been so widespread as to ren­der a coherent regulatory riposte impossible. The likely outcome is that tight capital requirements will be forced to serve as a catch-all res­ponse to risk. If so, the banking system will look more like that of the 1960s – a low-risk, low-return utility business. The ambitious and the avaricious will no doubt seek more exciting hunting grounds with hedge funds and private equity groups.
FT's criticism is misplaced. Many of the problems the quote above mentions- flawed incentives, poor governance, bad risk management- have their roots in high leverage. In the face of high leverage, managers will take all kinds of bad decisions- they will take excessive risks, for instance, knowing that the payoffs will be large if they succeed and costs to themselves pretty low if they don't.

So, while a great deal needs to be tackled by way of regulation, higher capital is an important starting point.

19 comments:

Adorable Bad Guy said...

Credit Default Swaps were to protect against credit risks and thats whats causing AIG the maximum grief.

I think overuse of complex instruments for hedging risks makes decision making even tougher. These instruments create a surreal world of smokes and mirrors where individual institutions may feel a false sense of security.

Most institutes did what everyone else was doing and that fuels such bubbles.

Commercial Financial Institutions are run by individuals whose are incentivized to maximize profit. The incentive to win big is too tempting compared to the dis-incentive for betting and losing. Therefore I think its tough for these institutes to govern themselves.

It has to be regulator's / govt job observe macro trends and actively create mechanisms and set triggers to call out such build ups. Its also their solemn duty to intervene when these triggers set off to avoid such systemic failures.

Akshat said...

Professor, don't you think the current crisis is more attributable to maturity mismatch between assets and liabilities than leverage because in the event of the availability of sufficient liquidity even the monstrous levels of leverage that these I-banks have maintained can be handled. In fact isn't this exactly what we are witnessing these days with the pure play I-banks like Lehman and Bear having folded up and the likes of JPM and Citi, who have the backing of their retail banking arms, not regarded to be in so much of a danger?

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