A bad, bad day August 2, 2011 at 6:06 am

I hate this. Really I hate it. But I have to admit that Alan Greenspan is right about something. Don’t worry, he is wrong headed about many things. The lone insight is this:

Bank managements, currently repairing their demonstrably flawed risk management paradigm, have been moving aggressively to build adequate capital to enable them to lend. For the moment they are expanding their loan portfolios only marginally. Most of the new capital appears to have buffer status, rather than being directly involved in spurring day-to-day lending. Deep uncertainty about our economic future, as well as the potential level of regulatory capital, has unsettled bank lending. More than $1,600bn in deposits (excess reserves) at Federal Reserve banks are lying largely dormant despite available commercial and industrial loans that, according to the Fed, entail “minimal risk” and are yielding far more than the 25 basis points reserve banks are paying on such deposits. The excess reserves thus seem to have taken on the status of a buffer, rather than actively participating in, and engendering, lending and economic activity.

There are two things going on here.

First, as Tyler Cowan points out, there is plenty of evidence that higher bank capital requirements lower growth, so there is a real policy choice between recovering faster from the recession and having a more stable banking system. Yes, Victoria, I know you want both, but sadly the world is not built that way. All Greenspan is doing is pointing out the unpalateable truth that we have chosen financial stability over growth.

Second, we want banks not to fail. Higher minimum capital requirements ensure that if they fail, more of the costs are born by equity holders and less by depositors or the deposit insurance body or senior creditors (Krugman is right about that). But what higher minimum capital requirements don’t do is to make the probability of failure much lower. This is because failures are typically liquidity rather than solvency driven, and so (as we have argued before) required capital is not available to absorb losses, only capital above the minimum is.

There is one more point Greenspan should have made and didn’t. It is that insurance mechanisms often involve lower aggregate cost than everyone having sufficient capital to support their own risk. This is why we let insurance companies take the tail risk for example of fires rather than everyone self insuring. Thus the total cost to the system of the state bearing some tail risk of financial instability is probably lower than asking each bank to separately capitalize it. Now I am not arguing that because of this the state should just write a blank cheque to the bankers (again). But I am suggesting that there is a legitimate debate to be had about capital requirements vs. insurance premiums; about risk mutualization and incentive structures.

4 Responses to “A bad, bad day”

  1. Does Greenspan think that a bank can take its excess reserves and lend these to a business or household?

    If so then he understands banking even less than I thought.

  2. what prevents a bank shareholder to undo this by simply borrowing against his bank shareholdings thereby undoing the buffer? the net effect is exactly the same, cash gets “released”. of course, there is no bailout if that does not work, but then why should there be one?
    i think the reason the insurance argument will never be used by bank executives is that any insurance inevitably comes with a premium payment and this is obviously a discussion they never want to have.
    this is why they only talk about the return-on-equity effect of higher capital, which is really funny since any shareholder can do that on their own..

  3. FINALLY I read about someone else who actually appreciates the merits of Greenspan’s argument, simply because they actually CONSIDERED what Greenspan is saying – regardless of what you think of his track record, character, or whatever ‘label’ that you’ve already assigned him.

    Its AMAZING – and sad – how many readers out there have got their their head so far up their ass in disdain for bankers or anyone that was ‘bailed out’ that they refuse to consider what is actually being said / go on autopilot about how much of a hypocrite, screw-up, etc. Greenspan / whoever else is.

    The irony of this of course lies in that this is symptomatic of the one of the root causes of the credit and banking crises in the first place – an over-reliance on regulatory rules (instead of actually THINKING about the prudent level of risk you are taking / level of capital you are holding) and credit ratings, and completely outsourcing the thinking to somebody else.

  4. Talking of Greenspan and banks – haven’t seen anyone mention this paper that argues why it makes sense for SIFIs to seek scale…