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Bank Capital Requirements: Still Broken

Before the financial crisis, global bank regulators set the stage for the mortgage bubble by rewarding banks that loaded up on mortgage securities with lower capital requirements.

The idea was that mortgage securities were far less risky than other types of investments.

Thanks to that idea, bank balance sheets were loaded down with mortgage securities, the mortgage market market was flooded with funds, and the prices of mortgage products failed to reflect their true riskiness.

Ooops.

And, as Holman Jenkins points out in the WSJ, the regulators are still in the business of loading the dice in favor of their view of risk.

Their latest solution, Basel III, would seriously hike the amount of capital banks must hold, but otherwise persists with the basic strategy of setting different levels of capital against different assets precisely to preserve the incentive of banks to invest in assets perceived as safe.

The fatal conceit, of course, is "perceived." Triple-A mortgage securities once were seen as safe. Greek bonds were safe. Under TBTF, when banks receive no discipline from their own creditors who expect to be bailed out, it falls on regulators not only to guess which assets are safe but to lean against the incentive of banks to categorize risky assets as safe in order to hold less capital against them.

How well regulators have performed this function can be guessed from a succession of global financial crises—as well as the rough-and-ready regulatory wisdom that has actually prevailed in those crises: "Big banks don't need capital. They just need liquidity."

As I explained earlier this week, this could actually make banks facing higher capital requirements more dangerous: adopting the regulators' view of risk will now pay off even better.

Until, of course, it doesn't.

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