Inside Financial Services

Not Lack of Capital. Lack of Liquidity.

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Andrew Atkeson and William Simon seem to believe that the recent volatility in bank stocks that they dread so can be curbed if regulators display “forceful leadership” and insist that banks lay in even more capital than they already have.

Sorry, the world doesn’t work that way. Here’s a news flash for all the erstwhile financial reformers who seem to think simply adding more capital is some sort of cure-all for the system’s ills: it’s not. Near-term financial panics don’t happen because of worries banks won’t have enough capital to absorb future credit losses. (Not that that’s not a legitimate concern. During times of non-panic, it’s usually investors’ single biggest concern.) Rather, panics happen because of worries banks won’t have enough liquidity to open their doors the next day. When Lehman Brothers failed, for instance, its core Tier 1 capital ratio was positively plump at 11%. Would the company have imploded anyway if that number were 20%, instead? Thirty percent? Almost certainly, yes. Here’s why: Lehman depended on overnight funding to fund itself. By the time things came to a head, no capital level would have been high enough to calm the fears of the company’s jittery liquidity providers, each of whom was by then was highly addled, and less concerned about Lehman’s eventual credit losses than it was determined that it not end up as Lehman’s last source of funding. A run on the bank, in other words.

That’s why all this ginned-up outrage over which banks lined up at the Fed’s discount window, and how much they took, is bogus. If the participants in a financial system become so panicky that they won’t lend to each other-and that happens from time to time-the system will freeze and collapse absent provision of liquidity by a lender of last resort. That’s what central banks are. If the Fed hadn’t been around to open its window in 2008, the result would have been a calamity. Would-be reformers who emphasize added capital and nothing else are offering a plan that won’t likely help much during the next crunch.

What do you think? Let me know!

4 Responses to “Not Lack of Capital. Lack of Liquidity.”

  1. Pat O'Brien

    Tom, I agree totally that liquidity should be the first priority of the regulators. I think they let themselves be bullied into focusing on capital in 4Q08 when few of the banks (Citi an obvious exception) needed it. It seemed to me that the debate over capital was fuel on the fire for bank funding and rather than go through the theatre of a “stress test” they should have made it clear that liquidity would be provided for all depositers. Certainly Paulson and probably Bernanke spent too much time worrying about the moral hazard and doing so, made things worse. Given the choice between the moral hazard and a run on the banks, I’ll take the moral hazard every time. The moral hazard didn’t exist in the early ’30s yet how many banks failed?

  2. DLB

    Come on now. The fact you claim Lehman had 11% capital describes the problem in a nutshell. Sure they had 11% capital. They also had a property portfolio that was overvalued by at least $15 billion. Not to mention a bucket of securities it was carrying on it’s books at twice their real value. The problem is capital and nobody believe what the real levels are. Sure, liquidity drives the bank run but concern over poor REAL capital levels is what leads wholesale funders to run away. Banks need to get used to operating with 12-15% capital and they need to get the hell out of lots of business they are no good at. The whole finance system is at least twice as large as it needs to be for an economy our size. (Europes is 4 or 5 times bigger than it should be)

  3. JRG

    And what causes bank runs and lack of liquidity? How about excessive risk taking compounded by 30/1 leverage. Higher capital ratios and lower leverage would have restricted the banks ability to engage in the high risk activities that brought down the financial system. Its more important that the regulators lower the risk profiles of the top .banks then allow them to run short term high risk growth strategies so that bank executives can meet their bonus objectives. One of the most effective ways to do this is with higher capital requirements. This the real startegy behind the FED’s higher capital requirements. They cant break them up but they reduce their threat to the financial system.

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