Basel III and bank capital for the long-run

Craig Pirrong and David at Deus ex Macchiato are worried that the minimum capital requirements set by Basel III will face the same problems as those created by earlier versions of Basel:  As banks seek to minimize their capital positions they are all pushed by the regulations into the same trades, this leads to the growth of unregulated financial sectors and crowded trades.

The question I have for proponents of this view is:  Why would a bank seek to minimize its capital position, when the purpose of capital is to protect the firm against unpredicted — or even unpredictable — losses?  There’s a reason Jamie Dimon has been feted for his “fortress balance sheet” approach to the crisis that everyone — including Chuck Prince — could see coming.

Whenever minimum capital requirements are the determinants of bank behavior, that’s a good indicator of a deep structural problem with the financial system, because it means that you have a financial system populated by banks that are more concerned with maintaining profitability in the short-run than with ensuring that the bank is a viable entity in the long-run.  In short, when banks are maintaining only minimal levels of capital, you have pretty clear evidence that repeated bailouts have resulted in the complete perversion of financial system incentives.

Note:  8-22-10 toned down the language a little.

4 thoughts on “Basel III and bank capital for the long-run”

  1. Three letters. R O E. Banks have a duty to shareholders. That means maximising ROE. To maximise a ratio, you maximise the numerator and minimise the denominator. E is the denominator. Errr, that’s it.

  2. Um, David, I think you missed something rather important. Banks are supposed to maximize shareholder returns. Those returns when correctly calculated include the risk that the shareholder loses his or her entire stake when the firm goes bankrupt.

    You’re basically saying that banks should maximize short-term profits and ignore the losses imposed on shareholders by failing to protect themselves from going bankrupt due to unanticipated/unanticipatable losses. I agree that this is what the banks have been doing (with as noted the exception of JPM) but it seems equally obvious to me that the policy is daft and most definitely not in the interests of shareholders (who don’t like holding shares with a value of $0).

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