"REthinking Capital Regulation" This article from the Aug 30 issue of the Economist was brought to my attention by Seth Bullard. Here's how it starts
REELING from billions of dollars of loan losses, banks have started to sell assets and rein in lending to keep their capital from eroding.
This may be individually rational, but collectively it is imposing a vicious cycle of tightening credit, weakening growth,
and further loan losses on the world economy. Small wonder that, once they get through this mess, many central bankers want to
raise capital requirements--at least during good times. Had banks been forced to hold more capital, the boom might have been more constrained,
and there would be less of a bust.
This sounds sensible. It may also be deeply flawed, according to a provocative new paper* presented at the Federal Reserve Bank of Kansas City's
annual economic conference in Jackson Hole, Wyoming. Compelling banks to hold more capital--typically, equity--goes against shareholders' interests,
because it results in a lower return on equity. This ultimately hurts economic growth because capital is diverted from projects that might have
higher returns. In addition, worthy borrowers are denied loans. It may also be counterproductive, by encouraging banks to game the system.
You can get the full text by going through the libary website. Type "Economist" into the periodical finder. Here's the full citation:
Finance And Economics: Capital ideas; Economics focus
Anonymous. The Economist. London: Aug 30, 2008. Vol. 388, Iss. 8595.
The actual paper is here: www.kc.frb.org/publicat/sympos/2008/KashyapRajanStein.08.08.08.pdf
Washington Post, Sept 26.Economists question Basis of Paulson's Plan Glenn Hubbard, Joseph Stiglitz and Greg Mankiw are all quoted in this article. Stiglitz:
"There is a kind of suggestion in the Paulson proposal that if only we provide enough money to financial markets,
this problem will disappear," said Joseph Stiglitz, a Nobel Prize-winning economist. "But that does nothing to
address the fundamental problem of bleeding foreclosures and the holes in the balance sheets of banks."
Hubbard:
"The root of the issue is recapitalizing banks," said Glenn Hubbard, dean of Columbia Business School and a former
chairman of President Bush's Council of Economic Advisers. "That could be done more efficiently through the
government injection of preferred equity. Then the market could figure out the prices of the assets."
Mankiw:
"The premise appears to be that the market is irrationally pessimistic," wrote Greg Mankiw, a Harvard University
economist and another former Bush economic adviser, on his blog this week. "That might be so. Nonetheless, one
has to be at least a bit skeptical about the idea that government policymakers gambling with other people's money
are better at judging the value of complex financial instruments than are private investors gambling with their own."