[OPE] Creative destruction and capital adequacy

From: Jurriaan Bendien <adsl675281@telfort.nl>
Date: Fri May 08 2009 - 06:57:11 EDT

While Dr Stiglitz wants the state to break up the banks, Mr Roubini thinks
the banks should be left alone to break up themselves:

Insolvent banks should feel market discipline
By Matthew Richardson and Nouriel Roubini

Published: May 6 2009 14:48 | Last updated: May 6 2009 14:48

(...) The response of governments worldwide to the financial crisis has been
to give the structure of private profit-taking an ever-growing scaffolding
of socialised risk. Trillions of dollars have been thrown at the system,
just so that we can avoid the natural process of creative destruction that
would take down these institutions' creditors. Why shouldn't the creditors
bear the losses? (...) Even if systemic risk were still present, the
government should protect the debt (up to some level) only of the solvent
banks, not the insolvent ones. That way, the risk of the insolvent
institutions would be transferred back from the public to the private
sector, from the taxpayer to the creditors. (...) Once unsecured debtholders
of insolvent banks lose, market discipline would return to the whole sector.
This discipline would force the remaining banks to change their behaviour,
probably leading to their breaking themselves up. The reform of systemic
risk in the financial system would be mostly organic, not requiring the
heavy hand of government. Why did creditors not prevent the banks taking
excessive risks before the crisis hit? For the very same reason creditors
are getting a free pass now: they expected to be bailed out. For capitalism
to move forward, it is time for a little orderly creative destruction.

Meanwhile, Der Spiegel ("The Power of Rating Agencies", 6 May 2009) writes:

"The power of the three big US rating agencies, Moody's, Fitch and Standard
& Poor's, remains unbroken. By awarding high ratings to junk securities,
they fueled financial market excesses. Now they are taking countermeasures
by brutally downgrading securities. In doing so, they are making the crisis
even worse. (...) The downgrades have triggered a massacre in the banks'
balance sheets.

Under the Basel II rules -- international banking regulations that have been
adopted by most countries -- the greater the risk, the more equity a bank
must have in its reserves as collateral for the security. For instance, if a
security is valued at 1 million euro ($1.3 million) and Moody's gives it a
Aaa rating, the bank must show only 5,600 euro ($7,390) in reserves for the
security. But when the same security is downgraded to Ba1, the required
capital reserve increases to 200,000 euro. If the rating is lowered to B1,
the bank must have 1 million euro in reserves to back the security.

This Basel II mechanism, which has exacerbated the crisis, also affects bank
lending to companies. The lower a company's rating -- whether it was issued
by one of the rating agencies or internally by the bank -- the higher the
required capital reserve. This means that the bank no longer has access to
the capital in this reserve, reducing its ability to lend money, for
example, to the small and medium-sized businesses so urgently in need of
capital. Statistics compiled by Germany's central bank, the Bundesbank,
already show evidence of a tightening in lending criteria.

To address the problem, politicians like Alexander Dobrindt, the general
secretary of the conservative Christian Social Union (CSU), want to see the
Basel II regulations suspended. But experts warn against such a move. "A
softening of the Basel II equity capital standard as an anti-cyclical
measure against the global recession could only take place as part of an
international consensus," says BaFin President Sanio. According to Sanio, a
national solo effort could be misinterpreted by international markets as "an
admission of complete failure, and as an acknowledgement that important
domestic banks are suffering from rampant equity capital deficiencies." For
this reason, Germany's coalition government is coming under growing pressure
to ease the burden on private and state-owned banks by creating
government-guaranteed depositories for toxic assets.

As I said about a year or so ago, the necessary result of this is a more
conservative stance in credit provision, which must slow down economic


E-mail message checked by Spyware Doctor (
Database version: 5.10260
ope mailing list
Received on Fri May 8 06:59:36 2009

This archive was generated by hypermail 2.1.8 : Sun May 31 2009 - 00:00:03 EDT