One Small Step Toward a Better Financial System

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By Simon Johnson and James Kwak
Tuesday, September 8, 2009; 8:30 AM

A little over a week ago, David Cho wrote an eye-opening article in this newspaper about the ability of America's four largest banks -- Bank of America, Citigroup, J.P. Morgan Chase and Wells Fargo -- to grow and profit from the financial crisis. Not only have these banks gobbled up rivals, but they now offer half of all mortgages and two-thirds of all credit cards and they enjoy a lower cost of funds than their smaller rivals because of the assurance that the federal government will bail them out when and if needed.

We have often argued that this would be the necessary outcome of the government's actions to rescue large banks on highly favorable terms and that fixing this problem is a top priority for public policy. Fortunately, Treasury Secretary Timothy Geithner seems to agree; Cho quotes him saying, "The dominant public policy imperative motivating reform is to address the moral-hazard risk created by what we did . . . in the crisis to save the economy."

Late last week, Geithner unveiled one pillar of his strategy to rein in the large banks: higher capital requirements. This is a first step, but there remains a long way to go.

Increasing capital requirements is conceptually uncontroversial. Capital, to simplify slightly, is the difference between a bank's assets and its liabilities; therefore, it is the buffer that protects a bank against a fall in value of its assets (think toxic collateralized debt obligations, or CDOs). The more capital, the less risk of insolvency, the more protection for creditors and counterparties and the less risk of failure in a crisis. Conversely, shareholders and managers (holding stock options) like banks having less capital because that means they put up less of their own money to earn a given dollar of profits.

Geithner's principles make sense -- but perhaps too much sense. In summary, they are:

(1) Capital requirements should be set to protect the financial system as a whole.

(2) Capital requirements should go up, especially for systemically important financial institutions.

(3) Banks should be required to hold high-quality capital.

(4) Risk-based capital measures should accurately measure risks.

(5) Capital requirements should be countercyclical, not pro-cyclical.

(6) There should be a flat limit on leverage.

(7) Regulators should monitor bank liquidity, not just solvency.


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