Wednesday, February 23, 2011

Andrew Haldane and Big Banks' Capital Cushions

Yves Smith disagrees with my take on Andrew Haldane's op-ed in the FT. After reading the op-ed, I wrote:

Strange op-ed by Andrew Haldane in the FT. No one is really pushing the argument that he's trying to shoot down.
The specific argument that Haldane was trying to shoot down, in his own words, was:
Regulators want big, complex banks to hold larger buffers of capital to protect the financial system. Big banks argue this is unnecessary because risk is diversified across their larger balance sheets.
Haldane was attempting to shoot down an argument about capital levels. It's one thing to argue that big, complex banks are safer because risk is diversified across their balance sheets — I've seen plenty of people pushing that argument. But it's entirely different to argue that because of this, big banks shouldn't have to hold larger capital cushions. I've still yet to see anyone seriously push this argument, and none of Yves' examples show anyone making this argument either.

It's perfectly consistent to argue that big banks are historically safer due to diversification, but that they should still hold larger capital cushions because of the greater potential harm caused by a big bank's failure. In fact, Haldane expressly acknowledges this in his op-ed: "[E]ven if there were [evidence that big banks are safer due to diversification], the case for big banks holding higher levels of loss-absorbing capital would not be weakened. That case rests not on the probability of large banks failing, but on their system-wide impact." So the fact that Dimon, Blankfein, and Bob Diamond all think that big banks are safer due to diversification provides no insight into their thinking on capital levels, which was the subject of Haldane's op-ed. (Yves tries to impute the argument about lower capital levels to Diamond by following his quote with, "Less risk implies less capital," but again, even Haldane acknowledges that this isn't necessarily true, and in any event, she's putting words in Diamond's mouth.) So there is still no evidence that any of the executives that Yves quotes think that big banks shouldn't have to hold larger capital capital cushions because of their diversification.

One reason you don't see any big US banks making this argument — and one reason I thought Haldane's op-ed was so strange — is that the point has been moot for over seven months now: Section 165 of Dodd-Frank already mandates that big banks hold larger capital cushions than other banks. That's a statutory requirement, and not subject to regulatory discretion. So while it's possible that UK banks are pushing the argument that big banks shouldn't have to hold larger capital cushions due to diversification, I've still not seen any evidence of this, and Yves supplies none.


Anonymous said...

Interesting post. But are you sure about Dodd Frank requiring big banks to hold more capital? Could it not be interpreted as risky activities (rather than firms) being subject to higher requirements, which could be met through already-agreed reforms to trading book capital etc? Would these not be far more gameable than, e.g. a 2% capital surcharge on bank x because of it's systemic importance?

This "solution" has obvious attraction for a regulator looking to avoid conflict, I'd recommend trawling through recent Treasury speeches for further hints...

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Further reforms are necessary.