Explaining capital adequacy requirements

Since we've emerged from the crisis, we've patched up our financial system a bit since it nearly collapsed -- but that’s all. It’s essentially the same, complete with the same design flaws. Instead of fixing the system, America has been focused on cleaning up the economy. It’s true that the economy needs a lot of attention, but by neglecting the repair work on our financial system -- which includes rectifying its design flaws -- we’ve left ourselves vulnerable.

One big reason for our failure to fix things is that there’s a lot of disagreement about where the design flaws are. Some people say credit default swaps are the problem; others blame securitization; the issue of declining lending standards gets a lot of attention, as does the government’s cheap money policy.

The government has settled on one area to fix: bank reserves, also known as capital requirements. It’s an easy decision to make because we were already working with other nations on bank capital requirements even before the crisis hit. It’s all part of something called the Basel Accord, which is an agreement on banking standards designed to reduce the risk in the global financial system. Right now we’re on the third round of standards, called Basel III.

A good way to think about capital requirements is to think about an airbag in a car. Under normal circumstances, the driver of the car doesn’t need an airbag; he gets from A to B without incident, the airbag doesn’t deploy, and he may think after a while that he’s such a safe driver that he doesn’t actually need an airbag at all. After all, airbags are very expensive.

But the government thinks airbags are necessary. Regardless of how good the driver might be, anything can happen on the road. If the driver has an accident, an airbag might keep him from serious injury or death, both of which can get very expensive for the government. So the government makes the driver pay for an airbag. 

Banks are like that driver. And the airbag is the cash reserve that banks are required to keep on hand in case of emergency. Most banks would rather not have to keep that cash on hand, first because they think they’ll be fine in an emergency (if an emergency even happens) and secondly because it’s expensive to keep money sitting around: it doesn’t earn any interest and someone has to keep an eye on it.

The thing is, that banks can run into trouble. As part of their daily business, banks borrow from each other all the time. But if banks decide to stop lending to one of their number, for whatever reason, that bank now has to depend on its own resources, and if the bank has little or no cash on hand, it will collapse, immediately. This is what happened to Lehman Brothers in 2008. In this kind of situation, a bank needs a reserve, an airbag to cushion it in an accident, and keep it alive. Then it can get its vehicle fixed, or replaced by insurance, and get back on the road.

The tricky question is, how big the bag should be. Some say it depends on the size of the bank: the bigger the bank, the bigger the reserve. Others argue it’s the kind of business the bank does. They say that a big plain vanilla retail bank might need less of a cushion than a smaller bank that has all sorts of risky businesses such as securitizations. 

About the author

Paddy Hirsch is a Senior Editor at Marketplace and the creator and host of the Marketplace Whiteboard. Follow Paddy on Twitter @paddyhirsch and on facebook at www.facebook.com/paddyhirsch101

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