The problem with banking is ...

That as a business it is not the kind of business that can run on 10 or 12% capitalization. The risk profile of banking as a business is not any lower than that of a company making widgets or a transportation company and arguably it is actually higher than most. And yet, banks are run on a tiny sliver of capital only (and whether it is 8% or 12% does not fundamentally make all that much difference).

In just about any other business, if 10% of your customers walk away - don't buy your widgets, or subscribe to your service or eat at your place, the business may become less profitable or not profitable at all for a while but it would not mean the end of it. In banking, if 10% of your customers (depositors) walk away, you are insolvent and practically out of business.

I have no idea what the "right" level of capitalization is for a business that has the risk profile of banking - maybe it's 35% or maybe it's 45%. I am sure it is not 12%. Not that there is much that can be done about it because the amount of economic pain that would follow a de-leveraging of  banking systems of the world to a level of, say, 40% is so huge that it would never happen.

There is an implicit "bargain" then that we all accept which is that occasionally the system will get wobbly and we the taxpayers will have to step in to backstop some part of it. This is simply the price to pay for the systemic excessive leverage and the only question is whether explicitly acknowledging this would help or not.

An analogy would be a car engine that by its design and materials specs could run for thousands of hours at 8,000 rpm without breakdowns but we decide to rev it up to 13,000 to go faster. We know full well that at that speed it will ocasionally break down and we will have to stop to repair it but the overall distance traveled at that higher speed with an occasional breakdown is farther than the distance that could be covered at lower speed with no stopping for occasional repairs.

We implicitly accept that trade off.


Comments

soldoiv said…
Couldn't agree more...
Anonymous said…
Turns out a similar argument was made from a different direction by Gary Gorton "Misunderstanding Financial Crises".

His argument is that bank failures are not about capital but liquidity and that systemic crises are about "obtaining cash".

To me that means that the banking system as it is currently structured is set up for a 2 Standard Deviations world which is what the world is on average. When it blips to 4 Standard Deviations then collective institutions need to step in and give the system time for the world to rever to the mean and that means supplying cash and a lot more cash than raising capital from 6% to 9% which really does not change much.

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