Capital Reserves: They’re Key to Financial Reform

October 23rd, 2011 at 10:44 pm

This is an important editorial from today’s NYT.

As financial sector lobbyists work to gut the financial regulation bill that Congress passed last year (Dodd-Frank)—and the Rs seek to repeal it—it’s somewhere between mind-numbing and soporific to follow the details.  There’s the Volcker rule (which restricts banks from proprietary trades—betting their own “book”), the Consumer Protection Bureau, derivatives regulations, and…

Capital reserves.

There are many malfunctions that contributed to the financial market meltdown in 2008, from liar loans, lousy underwriting, feckless credit raters, originate-to-securitize and distribute, to blind allegiance to Greenspanian self-correction hypotheses.  They all need to be addressed.

But if you forced me to choose one thing to change in perpetuity, it would be the rules governing capital reserves—the amount of capital banks and nonbanks (these rules should apply to institutions that speculate in markets, regardless of what it says above their doorways) must keep in reserve as a cushion against losses.

You can get a lot of the other stuff wrong, but with a strong capital requirement rule, you’ve built in a backstop against overleveraging.  In fact, after the crash, the extent to which banks were unsustainably leveraged was often discussed in terms of leverage ratios that were 40 and 50 to 1, instead of 10-1.

The banks and hedge funds and PE shops will fight tooth and nail on this one: a dollar sitting around creating a cushion can neither be used to buy Dutch tulip bulbs nor subprime MBSs.

To which we should all say: tough toenails.  You want to drive the global financial superhighway, be my guest.  But put on your seatbelt before you hurt yourself and everybody else…again.  And that means ample capital reserves.


Print Friendly, PDF & Email

4 comments in reply to "Capital Reserves: They’re Key to Financial Reform"

  1. davesnyd says:

    Help me, please– it has been a long time since freshman economics. Doesn’t the reserve ratio affect the money supply in an inverse relationship? So boosting it dramatically should decrease the money supply and cause a deflationary period? Won’t that be problematic right now? Won’t that require a pumping of cash into the system– which to some degree would help us print our way out of debt?

    • Jared Bernstein says:

      Fair point, but bank reserves are not in the “low” measures of liquidity, as I recall, like M1–though they would be in the higher ones. More importantly, I don’t believe there is a negative correlation between bank reserves in the range of Dodd/Frank and money supply (not so much boosting reverse requirements “dramatically” as much as dialing them back to historical ranges).

  2. comma1 says:

    Although in banker-land this may be a perfectly responsible and reasonable comment: “You can get a lot of the other stuff wrong, but with a strong capital requirement rule, you’ve built in a backstop against overleveraging.” In America, and actually, throughout the rest of the globe (as we have already seen) too big to fail is too big, capital reserves or not.

    This is like saying if we continue to perform surgery in the bathroom at the Vince Lombardi rest stop (NJ) then we should wash our hands before the first incision. The issue isn’t washing of hands, the issue is performing surgery in a truck stop restroom. These banks are too big to fail, they know it, Wall St knows it, the president knows it, and the people know it. They need to be broken and split or taken over. It is shocking that this administration failed to rectify it.

  3. perplexed says:

    How is it that these business are allowed to operate without providing insurance to protect the public from the damage they cause? You can’t even fill potholes in most places in the Country without purchasing adequate coverage for the damage your business might inflict on others.

    If the public is going to continue to provide insurance to these private business we need to charge appropriate premiums for the risk we’re taking on and demand full disclosure of any activities that expose us to risk so we can establish the correct premium. Without free public insurance, these TBTF institutions will disappear due to the “natural market forces” they so claim to love when the benefits accrue to them. We can no longer afford to provide this subsidy; as if we ever could.