Orderly failure vs. no failure March 12, 2014 at 3:00 pm
In the banking sector, which features leveraged institutions operating in a principal capacity, capital requirements are designed with the goal of enhancing safety and soundness, both for individual banks and for the banking system as a whole. Bank capital requirements serve as an important cushion against unexpected losses. They incentivize banks to operate in a prudent manner by placing the bank owners’ equity at risk in the event of a failure. They serve, in short, to reduce risk and protect against failure, and they reduce the potential that taxpayers will be required to backstop the bank in a time of stress.
Capital requirements for broker-dealers, however, serve a different purpose, one that, to be fair, can be somewhat counterintuitive. The capital markets within which broker-dealers operate are premised on risk-taking – ideally, informed risks freely chosen in pursuit of a greater return on investments. In the capital markets, there is no opportunity without risk – and that means real risk, with a real potential for losses. Whereas bank capital requirements are based on the reduction of risk and the avoidance of failure, broker-dealer capital requirements are designed to manage risk – and the corresponding potential for failure – by providing enough of a cushion to ensure that a failed broker-dealer can liquidate in an orderly manner, allowing for the transfer of customer assets to another broker-dealer.
As I said, it’s counterintuitive, but the possibility – and the reality – of failure is part of our capital markets. Indeed, our capital markets are too big – as well as vibrant, fluid, and resilient – not to allow for failure.