Saturday, April 19, 2008

New bank regulations aimed at shareholders

Just as the Fed is trying to inject more liquidity into the system to induce banks to lend more, comes a regulatory push in the opposite direction:
The world's leading financial regulators finally in 2004 producing a recommended rulebook called Basel II....It's based on the uncontroversial notion that bank shareholders need to have skin in the game, so if there are big losses, shareholders get wiped out before depositors or taxpayers are harmed. Like any company, a bank dies if its assets are worth less than its liabilities. The shareholders' skin in the game is the surplus of a bank's assets, such as the loans it makes and the securities it holds, over its liabilities, such as borrowings from other banks, savings accounts, and certificates of deposit. Basel II says the riskier the loans a bank makes, the more of a buffer shareholders are required to put up.

Here's the problem. Today, many banks already face so many risks that implementing Basel II as written will put them in a capital squeeze. They will either have to reduce risk by cutting back on lending, or sell more shares to give themselves a bigger capital buffer, or both. If the banks do lend less, it could cause an even steeper economic decline, which would lead to more defaults and cause banks to ratchet back even more, and so on in a downward spiral.

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