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Would Better Capital Requirements Have Prevented the Financial Crisis?

Wednesday, 29 Jun 2011 | 1:22 PM ET
AP

In the debate over raising capital requirements for mega-banks, one new argument that is making the rounds is that the regulators are addressing the wrong problem. The financial crisis was a liquidity crisis—not a capital crisis.

Slate’s Bethany McLean recently made a version of this argument:

Capital is not the same thing as liquidity, with which it's often confused. Liquidity is the ability to pay your current debts. It is possible for a bank to be solvent—i.e., have plenty of capital—but still fail because it doesn't have the money to pay the people who want their cash today. The risk of this gets bigger when a bank, which has assets that pay over a long time, funds itself with short-term paper.

Historically, most, if not all, bank failures have resulted from a run on the bank, meaning that short-term lenders or depositors yank their money because they doubt the value of the bank's assets. Once that fear sets in, it doesn't matter whether the bank is well-capitalized or not: It runs out of cash anyway. Bear Stearns and Lehman Brothers could plausibly argue, at the time of their demise, that they were well capitalized, but they still suffered a run because investors no longer trusted the value of the assets. The very situation in which a bank most needs a lot of capital is when investors start to suspect that the bank might be lying about the value of its assets. At that point, no amount of capital is enough.

That’s not quite right. It’s not true that no amount of capital would have been enough to save Lehman Brothers or Bear Stearns. What caused the collapse of liquidity at both firms was an unwillingness of counter-parties to extend credit to them. What lead to this unwillingness was a fear that the banks were inadequately capitalized to sustain losses from mortgage-related investments they owned.

To put it differently, market actors fears Bear and Lehman were inadequately capitalized. This fear was driven by a lack of transparency, a lack of trust, and actual capital inadequacy.

New capital requirements that are strictly limited to common equity—rather than some less easy to understand hybrid—would go a long way to preventing a liquidity run. Counter-parties wouldn’t need to trust the banks when they claim that they are adequately capitalized because the capitalization levels would be simple, transparent and high.

Remember back during the financial crisis when we heard a lot of talk about “tangible common equity” being the only reliable loss-absorbent form of capital. The banking executives hated that because they thought it was unfair for the market to hold them to a different standard than the broader regulatory capital definition of “tier 1 capital,” which was what the regulators used to measure of capital adequacy.

In some ways, the executives had a point. A gap had developed between what regulators considered a test of adequacy and what the markets considered the test. The executives were not used to answering to the markets in this way—they were geared to satisfying regulators. But the market didn’t have to adopt the regulators view of capital adequacy—and it didn’t.

Regulators are now trying to bridge the gap by requiring the biggest banks to hold additional common equity capital. The bet is that this will help prevent liquidity crunches by reassuring markets that the banks are adequately capitalized.

So saying that capital and liquidity are separate issues is a bit misleading. Firms might fail because liquidity dries up—but it is doubts about capital adequacy that evaporate liquidity.

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