Thursday, 30 April 2009

How much capital does a bank need?

Probably the best answer is the least amount that gives comfort and confidence to debt holders, regulators, and other stake holders. But that is a moving target.

Over the last twenty years people like me have spent a lot of time trying to construct and improve capital models. At its simplest, a capital model uses some measure of risk to deduce how much capital is required for some portfolio. The problem is that many of these measures of risk have proved highly fallible, and thus capital has been systematically understated. Moreover, thanks (1) to leverage and (2) to the fact that losses are a deduction from capital, even small capital mis-estimates can emperil a bank in a crisis like the current one.

These chickens (or in Citigroup and Bank of America's case, flocks of giant mutant turkeys) are coming home to roost. Six of the largest nineteen US banks require more capital, according to the FED: and you can be sure other banks around the world do too.

What you can be sure of in these discussions is that the numbers are essentially arbitrary. No one really knows how much capital a bank needs at any given point, not least because risk based capital models have lost their credibility. Capital is adequate if and only if it keeps the relevant stakeholders happy: and risk based estimates no longer keep people happy. So don't expect the negotiations of the coming weeks necessarily to make sense. It will all be about the deal that can be done when everyone gets around the table.

Update. Matthew Yglesias, via Gary Becker, has a nice characterisation of what we can expect from capital, and indeed regulation in general:
The best you can hope from a regulatory regime is ... [a] fairly crude rule will improve on the outcomes generated by the unfettered market... when we're looking at a regulatory regime that seems to be working okay, and the regulated parties start saying we need tweaks x and y and z and oh there's no danger there we should be very suspicious. We shouldn't count on being to fine-tune our results to perfection

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