Capital: breaking the cycle

One possible counter to the problem of procyclical leverage I discussed earlier is countercylical capital requirements. Willem Buiter discusses these in his FT blog, and makes a few interesting suggestions.

1. Regulatory capital adequacy requirements should apply to all highly leveraged financial institutions. Just to get around the obvious wheeze of the treasury department of a bicycle manufacturer being turned into a de-facto financial intermediary, the capital adequacy requirements should be applied to any highly leveraged institutions, whatever its label.

Hmmm. This is slightly problematic because some of these firms, perhaps most of them by number, neither have deposit insurance nor pose systemic risk. Imposing capital requirements on smaller firms reduces the diversity of the financial system and encourages larger firms. I cannot see a fair way of shading between large/systemically risky/should have capital and small/systemically not risky/does not need capital, but certainly applying capital to everyone is not necessarily the best way of ensuring financial stability.

2. Regulatory capital adequacy requirements should be counter-cyclical - they should be raised (by the central bank) during periods of boom and lowered during periods of bust. This will also help remedy one of the problems with the Basel I and II Accords.

Absolutely. And the mechanism to do this is available under Pillar 2. FSA could easily, for instance, have cycle-dependent trigger and target ratios. This is possibly the single most important policy change we need.

3. There should be regulatory leverage ceiling for all highly leveraged institutions. This ceiling should again be varied countercyclically by the central bank: the ceiling will be lower during booms and higher during busts.

If regulatory capital makes sense then this will happen anyway under 2. One important issue is that at the moment off balance sheet leverage is not captured by capital: if you fix that and a few other loopholes, then 2. should imply 3.

4. There should be regulatory maximum liquidity ratios (say ratio of liquid assets net of liquid liabilities to total assets) for all HLIs. This ratio should again be varied countercyclically by the central bank.

Yes, but the devil is in the detail in defining liquidity ratios. For instance backup CP lines were thought to be very low risk until the crunch. Preventing arbitrage of these rules will need careful initial drafting and then regular review to ensure they remain relevant.

5. Maximum loan-to-value ratios for all collateralised borrowing (including mortgages). Again, these ceilings should be raised during a slump and lowered during a boom.

An excellent idea, although these LTVs will have to be asset class specific, and figuring out how to change them in a prudent manner will also require a lot of work. Step function changes might be problematic, so finding a function of macroeconomic variables which automatically determines today's (or at least this month's) maxLTV is important.

[...] My examples are not meant to be exhaustive, just illustrative. They share the feature that they don’t have Fed staff crawling through the darkened corridors of investment banks at night. They require verification that the various credit ceilings are respected, of course. But the ceilings themselves are varied according to macroeconomic conditions, not firm-specific circumstances.

Why wouldn't you want the FED crawling through the banks at night, or indeed during the day? In particular, how can you ensure that a firm is doing the above correctly without supervision? The contract should be If you are a financial institution that either poses systemic risk, or can draw on central bank liquidity, or offers a product that is government insured (such as a bank deposit or certain kinds of insurance) then you have regulatory capital requirements and you are supervised.