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Fallacies and Irrelevant Facts in the Discussion on Capital Regulation

Central Banking at a Crossroads, 2014, p.33-50

Charles Goodhart, Daniela Gabor, Jakob Vestergaard and Ismail Ertürk editorial matter and selection 2014 ;2014 Daniela Gabor ;2014 Ismail Ertürk ;2014 Jakob Vestergaard ;2014 Charles Goodhart ;ISBN: 1783083042 ;ISBN: 9781783083046 ;EISBN: 1783083603 ;EISBN: 9781783083602

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  • Title:
    Fallacies and Irrelevant Facts in the Discussion on Capital Regulation
  • Author: Admati, Anat R. ; DeMarzo, Peter M. ; Hellwig, Martin F. ; Pfleiderer, Paul
  • Jakob Vestergaard ; Ismail Ertürk ; Charles Goodhart ; Daniela Gabor
  • Subjects: Accountancy ; Administrative law ; Assets ; Bank assets ; Bank capital ; Bank loans ; Bank management ; Banking ; Banking crises ; Banking regulation ; Business ; Business administration ; Business management ; Capital management ; Capital structure ; Commercial regulation ; Economic conditions ; Economic crises ; Economic disciplines ; Economic regulation ; Economics ; Equity ; Equity capital ; Finance ; Financial accounting ; Financial economics ; Financial instruments ; Financial leverage ; Financial management ; Law ; Loans
  • Is Part Of: Central Banking at a Crossroads, 2014, p.33-50
  • Description: IntroductionAs the financial crisis of 2007–2008 has compellingly shown, highly leveraged financial institutions create negative externalities. When a bank is highly leveraged and has little equity to absorb losses, even a small decrease in asset value can lead to distress and potential insolvency. In a deeply interconnected financial system, this can cause the system to freeze, ultimately leading to severe repercussions for the rest of the economy. To minimize social damage, governments may feel compelled to spend large amounts on bailouts and recovery efforts. Even when insolvency is not an immediate problem, following a small decrease in asset values, highly leveraged banks may be compelled to sell substantial amounts of assets in order to reduce their leverage; such sales can put strong pressure on asset markets and prices and, thereby, indirectly on other banks.Avoidance of such “systemic risk” and the associated social costs is a major objective of financial regulation. Because market participants, acting in their own interests, tend to pay too little attention to systemic concerns, financial regulation and supervision are intended to step in and safeguard the functioning of the financial system. Given the experience of the recent crisis, it is natural to consider a requirement that banks have significantly less leverage—that is, that they use relatively more equity funding so that inevitable variations in asset values do not lead to distress and insolvency.A pervasive view that underlies most discussions of capital regulation is that “equity is expensive,” and that equity requirements, while offering substantial benefits in preventing crises, also impose costs on the financial system, and possibly on the economy. Bankers have mounted a campaign against increasing equity requirements. Policymakers and regulators are particularly concerned by assertions that increased equity requirements would restrict bank lending and would impede economic growth. Possibly, as a result of such pressure, the proposed Basel III requirements, while moving in the direction of increasing capital, still allow banks to remain very highly leveraged (Blundell-Wignall et al., this volume). We consider this very troubling, because, as we show below, the view that equity is expensive is flawed in the context of capital regulation.
  • Publisher: Anthem Press
  • Language: English
  • Identifier: ISBN: 1783083042
    ISBN: 9781783083046
    EISBN: 1783083603
    EISBN: 9781783083602
  • Source: DOAB: Directory of Open Access Books
    JSTOR eBooks: Open Access
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