Why There Can't Be a Cap on Bank Capital Ratios

I don’t understand much of the mathematics in Nassim Taleb’s new paper, co-written with Charles Tapiero. But still I fear that the paper’s main point is hidden in a blizzard of equations:

…

The point here is that the risk to the taxpayer associated with any given bank grows exponentially with that bank’s size. Ceteris paribus, a bank with $500 billion in assets is a lot riskier than a bank with $400 billion in assets, not only 25% riskier.

Treasury seems to consider too-big-to-fail to be a binary thing: either you are, or you’re not, and if you are, then you’ll have to get by with higher capital requirements. But if that kind of a scheme is implemented, then it automatically creates a strong incentive for any too-big-to-fail bank to grow, and grow fast. The bigger that a TBTF bank gets, the more moral hazard can be palmed off onto the taxpayer, while the bank’s own capital ratios don’t have to rise at all.

Treasury I think should consider a scheme where capital ratios rise steadily with the size, risk, and interconnectedness of financial institutions, rather than simply falling into one of two buckets. And there should be no cap on how high those capital ratios can get. If such a cap is put in place, then every big bank will simply be given an incentive to blow straight past it.

Comments

[Skjellifetti:]

For someone who is as disparaging of economics as Taleb is, that sure looks a lot like a rather ordinary application of standard economic maximization. Seems like "Risk Engineering" is just economics dressed up in new clothes.

Nov 05 07:14 PM

[THofler:]

Wow, calculus of several variables! Aren't they teaching that in prep schools now?

Felix's example of the two banks assumes way more than Mr. Taleb's analysis states. The Taleb analysis basically just says that the 1st and 2nd derivatives are positive. There is nothing to suggest that the first derivative equals 1. The $500B bank may have 10% more risk than the $400B bank, if Taleb is correct. Even the standard exponential exp(x) does NOT increase rapidly if x is small.

The key take away from the credit crisis is that leverage kills, and very high leverage kills indiscriminately. The important thing is not to have unlimited higher levels on the capital ratios, but to put a rock solid FLOOR on capital ratios; or an absolute upper cap on leverage.

The insanity came about when Basel II said that leverage could be applied in a manner appropriate for the risk. Sounds reasonable, except that all risk metric science is flawed, and i-banks will game the system in ways that expand the leverage. (40 to 1 leverage is OK 'cause my risk model says its OK.)

Nov 05 07:32 PM

[Tom Armistead:]

What I don't like is banks that have huge amounts of derivative assets and liabilities in more or less equal amounts. Typically the assets are about 5% greater than the liabilities. They all make money. The theory is that the assets and liabilities offset each other, they are perfectly matched, a million repetitious trades, all of them yhielding small profits on the huge notional amounts.

For a long time it was credit default swaps but now the interest rate swaps are getting to be the big thing.

No need for calculus or elaborate equations, the whole system is too big and too highly leveraged and it will blow up when interest rates start bouncing around in the wake of the currency crisis that is likely to occur somewhere, sometime in the future.

Nov 05 08:25 PM

[TinyTim:]

"the risk to the taxpayer associated with any given bank grows exponentially with that bank’s size. "

My impression was the cap ratios were just that- ratios, and the actual capitalization required would increase with the bank size.

You intimate a single step-wise ratio.
Based on your quote above, they're all a bad idea if risk is exponential.

Based on other factors, such as interconnectedness, fianancial environment and management, the actual required capitalization would probably be prohibitive to maintain.

There's no substitute for busting up the banks.
A sliding cap rate based on size would add a measure of safety.
I would forget the other factors as regulators would probably not be successful with them.

Nov 06 11:26 AM

[st68:]

It seems to me that the only direct financial risk the government has for a TLTF bank is the FDIC insurance. So...instead of capping ratios, etc., how about a cap on the number of accounts that will be insured? Banks will then be limited in size by the number of insured depositers...I would not bank at an institution where my money was not insured...

Nov 17 11:22 PM