Capital Requirements and Transparency

A good article by Douglas J. Elliot on some of the (often ignored) costs of higher capital requirements for banks. Matt Yglesias has an interesting response. One thing in the Elliot piece caught my attention:

The “black box” nature of banks is a related problem. Investors must rely on the quality of lending, securities, and derivatives transactions that are difficult to understand from the outside. There is likely to be a limit as to how safe investors are willing to assume banks will be, at least in the proposed range of capital requirements. This may change in the long-term, if banks end up proving themselves to be very safe.

At the end of the day, the stability of the financial system is going to depend on how well lenders, regulators, and shareholders can evaluate the risks being taken on by large financial institutions. Its often very difficult to tell from annual reports how much risk a bank has taken on. This is the result of complex financial products and accounting standards that aren't able to keep up with them. As Elliot is pointing out, having higher capital requirements only works if banks don't offset the higher costs of added capital with riskier assets. It's a bad sign that he thinks investors will assume that the banks will do exactly that.

This is a hard problem to solve, but as I mentioned yesterday one of the goals of financial stabilization policy should be to encourage banks to hold assets that are widely traded, and thus priced more reliably.