Too much of a good thing

Can be non-wonderful, says Columbia economist Charles Calomiris of Anat Admati and Martin Hellwig’s The Bankers’ New Clothes. Specifically, their prescription of an off-the-rack 25% equity requirement for bank lending;

Admati and Hellwig assert that accomplishing a credible increase in the proportion of bank equity capital is a simple matter of increasing minimum regulatory requirements for the ratio of the book value of equity relative to assets. Would that it were so simple, but it is not; increasing the book equity ratio in an accounting sense does not necessarily increase true bank capital ratios, as I argue in my recent work (Calomiris 2013). Bank balance sheets do not capture many of the economic losses that banks may incur. Also, accounting practices can disguise the magnitude of loan losses, and regulators eager to avoid credit crunches are often complicit in doing so. The result is that banks’ true equity ratios can be much lower than their book values indicate. 

And, it won't be as big a free lunch as they seem to think;

An important implication of the various models of optimal capital structure is that forcing banks to raise their equity-to-asset ratio requirement generally will reduce banks’ willingness to lend. A large number of studies have shown that, when banks need to raise their equity-to-asset ratios, they often choose to do so by cutting back on new loans, which avoids the need to raise new equity and the high costs associated with it.

Which won't be just a one time cost, it will be a permanent feature of the banking system, and the economy.

Some of the most stable banking systems – Canada’s, for example – have had relatively low equity ratios. The low equity ratios of Canadian nationwide branching banks reflected their greater portfolio diversification and other risk-lowering attributes in contrast to the much riskier single-office (unit) banks in the US. The equity ratios of US banks have varied dramatically over time, and in ways that have clearly reflected changes in their asset risk. Equity ratios relative to asset risk are the key attribute of interest in prudential regulation, not equity ratios per se. Using simple historical equity ratios from some past example as a benchmark, without taking risk into account, can significantly overstate or understate the extent to which current equity ratios of large, global banks should be increased.

We await the sequel;  Fragile by Design... Unfortunately, not available until February 2014, so don't expect one in your Christmas stocking.