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Reason Foundation

Capital Reserve Requirements

Anthony Randazzo
June 10, 2009, 1:10pm

A primary cause for the financial crisis coming out of the Housing Bubble was the lack of capital at banks to meet reserve ratio requirements as asset values plunged. Critics point to highly leveraged financial institutions—around 56 to 1 at Citigroup—as being irresponsible and needing shorter leashes. To this end, there has been much discussion about reigning in the ability for firms to leverage too high and set stricter requirements for how much cash banks must have relative to debt. (Reserve ratio adjustments will likely also include rules tightening off-balance sheet accounting practices at banks that are used to avoid reserve requirements.)

The government has already required increased capital buffers from banking institutions in the wake of the stress tests. As of now the Federal Reserve and Treasury Department are confident that all financial institutions that pose systemic risk have enough capital—or are raising enough capital—to weather a continued market downturn. In the Fall, any institution that has not met their required capital reserve standards will face nationalization.

Given these actions, discussion of increasing capital reserve ratios is focused on maintaining long-term stability. The independent “Group of 30” collection of economists led by former Federal Reserve chairman Paul Volkher, has suggested doubling reserve ratios. And the higher level of capital requirement may not necessarily be a bad thing. It is clear that firms should have set more aside incase asset values dropped to quickly.

But the point of a reserve ratio is to protect a company from its own mistakes and others from potential fall out. It’s like creating rules for the foundation of a building so that the tower doesn’t fall down and hit others near by. The question is: should regulators step into keep this problem from happening again the future by increasing ratios? Or can firms do this themselves given the proper incentive structure?

Regulators also have to consider that every percentage the ratio limit is tightened is a less of an opportunity for banks to use their resources to create wealth. Just limiting the height of all buildings in a specific area to 500 feet off the ground restricts innovation and ignores rules for the foundation. Consider the lost value in Washington D.C. because the city is spread out due to laws limiting the height of buildings.

One aspect that lawmakers should consider is how the implicit government too big to fail support fueled the willingness for firms to increase their leverage. Banks are much more likely to hold a 5 percent margin if they believe the government, or collective market, will cover a big loss. There are many factors that played into the decision making process of financial institutions as they took on more risk, and raising ratios does not address that aspect of financial crisis genesis. This is a question of what regulators allowed to fill the foundation of thinking, which must be answered before considering if the building was too tall.

Ratios may need to be increased, but just as important is ensuring the foundation—ensuring that institution directors have enough stake in the success or failure of their company that they will act responsibly—is stable. Without enough skin in the game, firms are more likely to take high risks. The moral hazard created by previous bailouts and rescues orchestrated by Washington bears just as much responsibility as the risk taking institutions themselves. Clarifying the role of the government and consequences for losses will go a long way to ensuring better risk management.

If there is a really good reason to increase reserve ratios, it might be to help stop inflation. Economist Arthur Laffer talking about the increased money supply that is driving inflation concerns said in a WSJ op-ed today:

the Fed should increase reserve requirements on member banks to absorb the excess reserves. Given that banks are now paid interest on their reserves and short-term rates are very low, raising reserve requirements should not exact too much of a penalty on the banking system, and the long-term gains of the lessened inflation would many times over warrant whatever short-term costs there might be.

Anthony Randazzo is Director of Economic Research


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