Economics focus: Capital ideas

"Can banks use a “capital insurance” scheme to dampen future crises? REELING from billions of dollars of loan losses, banks have started to sell assets and rein in lending to keep their capital from eroding. This may be individually rational, but collectively it is imposing a vicious cycle of tightening credit, weakening growth, and further loan losses on the world economy. Small wonder that, once they get through this mess, many central bankers want to raise capital requirements—at least during good times. Had banks been forced to hold more capital, the boom might have been more constrained, and there would be less of a bust. This sounds sensible. It may also be deeply flawed, according to a provocative new paper* presented at the Federal Reserve Bank of Kansas City’s annual economic conference in Jackson Hole, Wyoming. Compelling banks to hold more capital—typically, equity—goes against shareholders’ interests, because it results in a lower return on equity. This ultimately hurts economic growth because capital is diverted from projects that might have higher returns. In addition, worthy borrowers are denied loans. It may also be counterproductive, by encouraging banks to game the system. ..." (2008-8-28)
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