Institute for Financial Transparency

Shining a light on the opaque corners of finance


Economists never learn: bank capital

Previously I discussed how the Economics/Finance profession is incapable of learning anything from someone without an Economics/Finance PhD.

As an example of this, I discussed the Information Matrix I developed.  The matrix includes a quadrant for transactions that occur when both buyer and seller don’t have the information necessary to know what they are buying and selling (for example: subprime mortgage-backed securities or bank stocks).  This quadrant is ignored by the Economics/Finance profession who focus on the other three quadrants (perfect information and information asymmetry – lemon problem or antiquities dealer problem).

Today’s example of the inability of the profession to learn is bank capital and the argument that it prevents financial crises or taxpayer funded bailouts.

A little background on myself. While working for what is now a Too Big to Fail bank in its capital management area, I worked on what eventually became the Basel I capital regulations.  I also went through the coursework used by the Fed to train its bank examiners.  Taken together, these experiences give me a considerable amount of expertise on the subject of bank capital.

In 2009, I met the most vocal champion from the academic community for higher bank capital requirements.

Then and in subsequent communications I explained why higher bank capital requirements in the absence of transparency sound good in theory, but don’t result in the expected benefits in reality.

The argument for why this is true goes like this:

  1. An easily confirmed observation:  During the financial crisis that began on August 9, 2007, no too big to fail bank in any country was forced by its regulators to recognize all the losses on and off its balance sheets.
  2. Why weren’t these banks forced by their regulators to recognize their losses? Bank regulators told us why.  They feared recognition of these losses would trigger a further financial panic as investors saw bank book capital levels written down.

Wow!  Based on the actual performance of financial regulators we know in the face of a financial crisis bank book capital will never be used to absorb losses as doing so could trigger much greater financial panic.

This fact has no apparent influence on the academic Economics/Finance profession and its call for higher capital requirements.  Even today, the knee jerk default position of these academics is to trot out the call for higher capital requirements.

Please note, the introduction of transparency results in bank capital actually being used while at the same time defusing the bank regulators’ concerns over causing greater panic.

How does transparency do this?

It makes market discipline on the banks possible.  When the market can see what the banks exposures are, the market is fully capable of estimating what each bank would look like after each bank has recognized its losses.  As a result, there is no benefit to a bank from not recognizing its losses and this recognition doesn’t cause greater financial panic as the market knows what to expect.

When I point this out to the members of the academic Economic/Finance profession, they acknowledge I am right and transparency is THE NECESSARY CONDITION for higher bank capital to be meaningful (by the way, transparency makes it into one of the last chapters of the book they like to cite).

However, they still call for higher bank capital without ever mentioning transparency is necessary if any of the benefits of higher bank capital are ever going to be realized.

So why would they continue to call for higher bank capital requirements without mentioning the need for transparency?  Do they have any idea how stupid and out of touch with reality calling for higher bank capital requirements without mentioning the need for transparency makes them look?

My best guess is because they are incapable of learning anything from someone without an Economics/Finance PhD.

Why is this true?  Because the only feedback they care about is from their circle of academic/regulatory Economics/Finance PhDs.  Everyone else’s feedback isn’t worth listening to as they don’t have the appropriate level of education.