System of Capital Requirements 10.docx

Emerging anecdotal evidence also indicates that banks in this country are assuming additional asset/liability risk at present that could evolve into the next economic bubble. For instance, several articles have mentioned recent improvements in bank profitability due to rising net interest margins. (22) As noted in one article, "(n)et interest margin is the percentage difference between the interest income produced by a bank's loans and investments and the interest paid on certificates of deposit, savings accounts and other deposits." (23) Although this higher net margin is improving bank returns in the current environment, it involves significant asset/liability mismatch risk that can produce losses if interest rates begin to rise. Note that bank loans frequently have intermediate durations while bank funding sources such as CDs, savings accounts and other deposits can become quite short term in nature if customers move to higher-rate investments when interest rates rise. This situation (known as disintermediation) reduces net interest margins or even produces a loss for the banks in a rising rate environment, since they would have to replace current low-cost funding for their loans with funds paying higher interest rates. (24) A recent article states that "the Fed ... (has) increasingly noted the threat of rising inflation ... (recognizing that a) shift to rate increases would cut into net interest margins at U.S. banks." (25) Thus, there is an understanding of this risk, but the current system of capital requirements does nothing to address it. Under the system of capital requirements described in this article, banks would be required to keep a portion of any current returns from following a mismatch strategy (as opposed to a matched strategy), and this capital cushion would then be available to cover losses that materialize if interest rates do rise in the future. This approach should also reduce the likelihood of a bubble forming due to overvaluation of bank margins. Why Fair-Value Accounting Is Not Incompatible with a Properly Structured System of Countercyclical Capital Requirements Proper management of financial institutions is about adding value to the firm. As shown in Appendices 1 and 2, this means proper evaluation of both returns and risk, not just focusing on short-term earnings with no adjustment for risk. When managers focus only on short-term earnings, economic bubbles often form. The mechanism involved in formation of these bubbles is also illustrated in Appendices 1 and 2. To prevent this short-term focus, regulations should be revised so that financial managers are rewarded based on the creation and preservation of value. A system of fair-value accounting supports this objective if all assets and all liabilities are marked to their current value and if the pricing is done properly in making such valuations. The system of countercyclical capital requirements proposed in this article should be consistent with such a fair-value accounting system. As noted previously, the key measure that is used to gauge the risk of default within a firm under this system is the sufficiency of the firm's current (market) value of assets to cover the current (fair) value of the firm's liabilities or debt. So a full fair-value accounting system that aims to increase market value of assets (A) relative to fair value of liabilities or debt (D) should be consistent with a countercyclical system of capital requirements designed to prevent default. But what about the claim that fair-value ac counting requires banks to take losses when the price of their assets falls, thus punishing firms during the rough times? (26) This view arises from the current system of capital requirements, which calls for fixed capital ratios regardless of the level of risk. As a result of this system, capital is raised whenever equity value falls relative to assets (which often occurs when asset value is falling). However, this is not a requirement of a fair-value accounting system. Rather, it is a function of the current system of capital provisioning. If capital requirements are set as recommended in this article, however, capital would rise as asset risk and asset/liability mismatch rises. Thus, capital is accumulated well in advance of a decline in asset value and is then available to cover any decline in assets when the risk ultimately emerges. This mechanism in itself should be countercyclical. It also rewards firms when they are willing to refrain from taking on such risks, since they would have a lower capital requirement as a result. Consequently, increases in required capital would not necessarily coincide with a decline in the market value of a firm's assets. Instead, equity capital of a firm should rise as the firm is implementing strategies that substantially increase the firm's risk. While there is still a possibility that a fall in the market value of assets could be concurrent with an increase in required capital, this should only occur if the firm's equity ratio (E / [D + E]) falls below its required level as a result of the fall in asset value. If, for instance, the decline in asset value is not accompanied by an offsetting decline in liability value, the economic capital ratio of the firm may fall, which could necessitate a capital injection under the system proposed in this article. In contrast to the current capital system, however, where such an increase in capital would be inevitable, under our proposed system, the firm would have options for mitigating the increased capital requirement by better matching its assets and liabilities or replacing risky assets with equal-valued assets that have a lower level of risk. Effectively, this means that a company can access its capital during difficult times if it is willing to unwind the risks that gave rise to this capital in the first place (for example, reduce asset risk, reduce mismatch risk). The important point is that fair-value accounting does not necessarily require an increase in capital as asset value falls if capital is set based on rising risk. So capital requirements are decoupled from the accounting system to a large degree. Therefore, the capital system proposed in this article can be used concurrently with fair-value accounting without harming the goal of countercyclical capital formation. And if both systems are used properly (accurately reflecting the economic risk and returns of all assets and liabilities), they should work in tandem to prevent future bubbles.