Rethinking Capital Regulation

Anil K Kashyap

Recent estimates suggest that U.S. banks and investment banks may lose up to $250 billion from their exposure to residential mortgages securities.1 The resulting depletion of capital has led to unprecedented disruptions in the market for interbank funds and to sharp contractions in credit supply, with adverse consequences for the larger economy. A number of questions arise immediately. Why were banks so vulnerable to problems in the mortgage market? What does this vulnerability say about the effectiveness of current regulation? How should regulatory objectives and actual regulation change to minimize the risks of future crises? These are the questions we focus on in this paper.

Our brief answers are as follows. The proximate cause of the credit crisis (as distinct from the housing crisis) was the interplay between two choices made by banks. First, substantial amounts of mortgage-backed securities with exposure to subprime risk were kept on bank balance sheets even though the “originate and distribute” model of securitization that many banks ostensibly followed was supposed to transfer risk to those institutions better able to bear it, such as unleveraged pension funds.2 Second, across the board, banks financed these and other risky assets with short-term market borrowing.

This combination proved problematic for the system. As the housing market deteriorated, the perceived risk of mortgage-backed securities increased, and it became difficult to roll over short-term loans against these securities. Banks were thus forced to sell the assets they could no longer finance, and the value of these assets plummeted, perhaps even below their fundamental values—i.e., funding problems led to fire sales and depressed prices. And as valuation losses eroded bank capital, banks found it even harder to obtain the necessary shortterm financing—i.e., fire sales created further funding problems, a feedback loop that spawned a downward spiral.3 Bank funding difficulties spilled over to bank borrowers, as banks cut back on loans to conserve liquidity, thereby slowing the whole economy.

The natural regulatory reaction to prevent a future recurrence of these spillovers might be to mandate higher bank capital standards, so as to buffer the economy from financial-sector problems. But this would overlook a more fundamental set of problems relating to corporate governance and internal managerial conflicts in banks—broadly termed agency problems in the finance literature. The failure to offload subprime risk may have been the leading symptom of these problems during the current episode, but they are a much more chronic and pervasive issue for banks—one need only to think back to previous banking troubles involving developing country loans, highly-leveraged transactions, and commercial real estate to reinforce this point. In other words, while the specific manifestations may change, the basic challenges of devising appropriate incentive structures and internal controls for bank management have long been present.

These agency problems play an important role in shaping banks’ capital structures. Banks perceive equity to be an expensive form of financing, and take steps to use as little of it as possible; indeed a primary challenge for capital regulation is that it amounts to forcing banks to hold more equity than they would like. One reason for this cost-of-capital premium is the high level of discretion that an equity-rich balance sheet grants to bank management. Equity investors in a bank must constantly worry that bad decisions by management will dissipate the value of their shareholdings. By contrast, secured short-term creditors are better protected against the actions of wayward bank management. Thus the tendency for banks to finance themselves largely with short-term debt may reflect a privately optimal response to governance problems.

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