Controlling vs Collateralizing Risk

Regulatory reforms that focus on improving risk controls rather than increasing capital reserves are the better path for the future of banking, according to Katsunori Nagayasu, president of the Bank of Tokyo-Mitsubishi UFJ and chairman of the Japanese Bankers Association (“How Japan Restored Its Financial System,” WSJ, Aug 6, 2009).

Regulatory authorities around the world are currently discussing ways to prevent another financial crisis. One idea is to mandate higher levels of capital reserves. Japan’s banking reform shows that a comprehensive solution would work better.

Requiring banks to increase capital reserves is itself, “risky.” For one thing, banks may not be able to raise sufficient capital in the equity markets to meet the revised capital requirements. Moreover, raising capital requirements tends to disadvantage banks that focus on traditional borrowing and lending transactions, and advantage banks that trade and take risks with their own accounts.

A new regulatory framework must also distinguish between banks whose main business is deposit taking and lending—the vast majority of banks worldwide—and banks that trade for their own account. The recent financial crisis demonstrated that balance sheet structure matters. Trusted banks with a large retail deposit base continued to provide funds to customers even in the depths of the crisis, whereas many banks that relied heavily on market funding or largely trading for their own account effectively failed. Investment banks with higher risk businesses by nature should be charged a higher level of capital requirement—otherwise, sound banking will not be rewarded.

That the government has undertaken to save only the largest banks under the “too big to fail” presumption is of concern to the public for a variety of reasons, not the least of which is that such an approach may actually reward the banks that are taking the biggest risks, while closing those that have played by the rules. Additionally, requiring banks to maintain excessive capital reserves may sound good, but high reserves brings reduced capital efficiency, particularly at a time when money is scarce.

Regulators would be wise to consider the capital efficiency of the reforms they intend to invoke, or the current recession could extend well into the future. The US should take a lesson from the Japanese banking experience and focus on new ways to control risk, rather than simply collateralizing it.