Engineering the Financial Crisis: Systemic Risk and the Failure of Regulation

2. Capital Adequacy Regulations and the Financial Crisis: Bankers' and Regulators' Errors

2 Capital Adequacy Regulations and the Financial Crisis: Bankers' and Regulators' Errors A bank’s ‘‘capital’’ is the security blanket it needs because of the fragile nature of banking. Any corporation’s capital boils down to its net worth, or ‘‘the residual after subtracting liabilities from assets’’ (Gilliam 2005, 293, emphasis added). ‘‘The greater a bank’s capital, the more it can absorb net losses before liabilities exceed assets’’: capital serves as a buffer against bankruptcy, which occurs when a corporation’s assets dip below its liabilities . Capital is thus rightly seen as a ‘‘cushion’’ for any corporation, but it is especially important for banks. This is because of the unique nature of a (commercial) bank’s assets, from which its liabilities are subtracted to determine its net worth. A manufacturing corporation’s assets, for example, will probably consist largely of cash and items that could be sold in case of bankruptcy to meet its liabilities, such as its factories and equipment, inventory of unsold goods, real estate, and so on. In the case of a bank, however, most of its assets are not plant or equipment; they are loans—mortgages, business loans, and credit-card accounts, for instance. A sufficient ‘‘capital’’ buffer, in the accounting sense of the term with which we are concerned here, is important to banks because of the general unpredictability of these assets. A factory may unexpectedly burn down, but such possibilities are actually ‘‘risks’’ in Keynes’s sense, and therefore they can be insured against. 58 Chapter 2 The insurance company calculates the odds of a fire based on its interpretation of relevant historical factors: the neighborhood in which the factory is located, the type of manufacturing performed in the factory, and so on. It makes predictions of future probabilities based on these factors, although, since interpretation is involved, the predictions may be wrong. Meanwhile, however, the insured corporation is guaranteed payment in the case of fire—as long as the insurance company itself remains solvent. The idea behind using CDS to insure mortgage bonds was that the risk of mortgage holders’ defaults could also be calculated based on historical data. These calculations were performed by the rating agencies, the interpretations of which were apparently erroneous. We discuss that further in the next chapter, but here, we deal with the question of why so many commercial banks ended up, in effect, building factories (income-producing assets) in neighborhoods that were extra vulnerable to fires. On the other side of the ledger from assets are a corporation’s liabilities. These are funds legally owed to a corporation’s employees, vendors, and anyone else from whom the corporation has borrowed money or entered into legal obligations to deliver payments, goods, or services. In addition, corporations will often incur liabilities in the form of loans, lines of credit, and corporate bonds. All of these liabilities must be paid off before any profits are distributed to investors in the form of dividends. With commercial banks, however, there is an additional type of liability: customers’ bankaccount balances. The defining feature of a commercial bank is that it gets some of its funds from customers’ accounts. But with the exception of certificates of deposit and other bond-like (time) deposits, which need only be paid off at specified dates, banks must stand ready at any time to pay a given customer the full amount she has lent to the bank by depositing funds in her checking or savings account. Like other corporations, banks borrow funds from other banks and from bond purchasers; unlike other corporations, they also borrow funds from depositors. The special fragility of banking stems from the fact that banks then lend much of the money they have borrowed to mortgagors, credit-card account holders, and businesses: banks are both borrowers and lenders of the same money. The borrowed money constitutes part of the bank’s liabilities, yet when it is lent out, it also constitutes part of the bank’s assets. To be sure, those who borrow money from a bank are legally obliged to pay back these loans; but they might prove unable to do so. If they default Capital Adequacy Regulations and the Crisis 59 on their obligations, the bank is left holding the bag; it is still obligated to its creditors (depositors, bond holders, and so on). This makes a capital cushion especially important for a bank to cover unexpected declines in...