Next Bailout Step: Lowering Capital Requirements

We’ve suggested that one mark-to-market fix that could work is a reduction of reserve requirements, so that banks can write down assets to appropriate levels without entering into a regulatory violation.

Reserve requirements are already arbitrary, so there’s nothing intrinsically wrong with lowering or increasing them. Warren Buffett actually supports this idea as well, which is nice in these sense of giving it some legitimacy. Jim Chanos likes it too.

It has the benefit of being transparent, as investors can still look at honest numbers and decide whether they want any part of the bank or not.

The response, though, from some is that this is nuts. What! Encourage banks to be even less cautious? Are you crazy?

John Hempton makes a good point on how this could work after the Geithner scheme goes through:

Once you have the true bank capital position determined you can allow the banks with adequate capital to muddle through (possibly with government liquidity support) and force the insolvent banks to raise capital.  If they can’t raise the capital you nationalise them.

As the exam is now objective – not self assessed – a lower capital standard (say a third normal) should be allowed.  High capital standards are really required in part because banks lie.  If they can’t lie a lower standard should be acceptable.  Moreover you suspend dividends whilst they muddle through.

Again, the thing to remember is that any regulatory capital requirements are arbitrary. There’s no “right” amount. Get some semblance of an honest number, and it becomes safer to make the change. It’s certainly better than reverting to some kind of mark-to-fantasy accounting, where investors and counterparties have zero insight into the actual health of the institution.

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