Comment on Coates: How Do Bank Regulators Determine

Capital Adequacy Requirements?

Eric A. PosnerUniversity of Chicago Law School

Fall 2014

Outline

1. The Theory of Bank Capital Adequacy Regulation2. The History of Bank Capital Adequacy Regulation3. Regulator’s Justifications4. Effects5. Lessons

Why regulate capital?

• The key idea is that whenever a bank makes a loan, it imposes a tiny negative externality on others by raising the level of risk in the system• Capital regulation counters this incentive to take risk by forcing

shareholders to bear more of the downside (as would Pigovian taxes on debt)

The History of Bank Capital Adequacy Regulation

1. Pre-history to 1981No formal rules; capital part of all-things-considered evaluation of bank

2. 1981 RegulationsMinima in 5-7 % range (primary/total; community/regional)

3. 1985 RegulationsRaised minima; collapsed community/regional distinction

4. 1989 RegulationsNominal increases but added risk-weighting

5. 2007 RegulationsNominal increases but added internal valuation models

6. 2013 RegulationsSubstantial increases

Effects (None)

1950 1960 1970 1980 1990 2000 20100

0.02

0.04

0.06

0.08

0.1

0.12

Ratio Law

Lessons

• Regulators typically provided boilerplate explanations for the rules:

to inject more objectivity and consistency into the process of determining capital adequacy, to provide nonmember banks with clearly defined goals for use in capital and strategic planning, and to address the issue of disparity in capital levels among banks in different size categories by adopting uniform standards regardless of the size of the institution.

• Regulators repeatedly noted that effect of regulations would be limited.

The agencies’ analysis also indicates that the overwhelming majority of banking organizations already have sufficient capital to comply with the final rule. In particular, the agencies estimate that over 95 percent of all insured depository institutions would be in compliance with the minimums and buffers established under the final rule if it were fully effective immediately. (2013)

• A few cost-benefit analyses were incompetent• Calculated the wrong costs (underwriting costs, not lost profits)• Did not estimate benefits (avoided financial crises)

Criticisms & the EPA Analogy

• Difficulty with quantification• Valuation of life; unspoiled wildernesses; lost recreation opportunities• Discounting• How much should the regulator invest in information?

• The problem of manipulation• Cost-benefit analysis as a bureaucratic/judicial barrier

• Corrosion-Proof Fittings• Business Roundtable

• Second-order benefits• Constraints and transparency• Stimulation of academic research and public debate

Conclusion

• Massive regulatory failure• Common view is that inadequate capital contributed to financial crisis of

2007-2008

• Why?• Not so much regulatory forbearance as in S&L crisis and other cases• It was the result of systematic application of excessively weak regulatory

standard (“norming”)

• Could regulators have done better?• Suppose that they had been required to conduct cost-benefit analysis?

• What about academics (e.g., Admati & Hellwig)?