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Myerson: Rethinking the Principles of Bank Regulation
To understand why this role of monitor
and lender of last resort has been filled by
a publicly controlled central bank, it may
be useful to review the history of America’s
banking crisis in 1907. This was the last such
crisis before the Federal Reserve System was
created to serve as America’s central bank.
When a series of bank failures threatened to
cause a loss of public confidence in the entire
banking system, somebody had to do the
hard work of providing credible information
to the market about which banks were still
solvent. In America in 1907, the monitor and
lender of last resort was J. P. Morgan himself.
Working with his expert staff, sometimes
late into the night at his home in New York,
Morgan reviewed the accounts of threatened
banks and led a consortium of investors to
supply liquidity to the banks that he found
to be healthy. With his leadership, the extent
of the panic was contained (see Bruner and
Carr 2007). In the same period, however,
J. P. Morgan was often accused of using his
great financial influence to create monopo-
listic cartels. Whether such allegations were
true or not, his central power over channels
of credit throughout the economy certainly
had potential to be used for such purposes,
against the interest of the consuming public.
Thus, the role of monitor and lender of last
resort should be recognized as a vital natu-
ral monopoly, maintaining costly expertise to
provide public information, but with monop-
oly power that should be publicly controlled.
4. Clear Accounting Is of the Essence
The key question of bank regulation is
how to define the amounts of equity capi-
tal that banks should be required to have.
Since the 1980s, central banks around the
world have formulated their regulatory
rules under the coordinating guidance of an
international committee on banking super-
vision based in Basel, Switzerland. Admati
and Hellwig are deeply critical of the
general framework that this Basel process
has generated. Martin Hellwig was actually
a professor in Basel for several years while
international central bankers were meeting
there to develop their principles of bank
regulation, but the Basel Committee on
Banking Supervision made very little use of
outside professional advice from any social
scientists in this period (see Goodhart 2011,
p. 572). Before 2008, the process of defin-
ing standards of bank regulation also did
not get much attention from most econo-
mists (including the author of this review),
but the banking industry was always paying
attention. Admati and Hellwig’s critique
should raise concerns that the whole Basel-
endorsed framework of bank regulation
may need fundamental reconstruction.
First and foremost, we should recognize
that the fundamental problem of finance is
about people having different information.
Millions of people entrust their savings to
bankers and other financial intermediaries
who have better information about where
the money should go than the average inves-
tor has. The whole system depends on moni-
toring to maintain investors’ trust in their
financial intermediaries. Thus, measurement
is of the essence here.
In the financial report of any private cor-
poration, the values of all assets that the
corporation owns are listed on the left side
of the balance sheet, and the values of debts
owed by the corporation are listed as liabili-
ties on the right side. The estimated book
value of the capital or equity that belongs
to the owners of the corporation is then
computed to be the total value of all assets
minus the total value of all debt obliga-
tions, and it is listed also on the right side
as the last liability, so that the balance sheet
balances. The accounting profession has
defined standards for estimating the values
of all these assets and liabilities, but ulti-
mately the value of capital that is computed
from these accounting estimates must be
Journal of Economic Literature, Vol. LII (March 2014)
204
recognized as only
an estimate of the value
of the owners’ equity.
3
For any publicly traded corporation, the
market also provides an estimate of this
equity value, which can be computed by mul-
tiplying the current price per share of stock in
the corporation by the total number of shares
outstanding. With the passions of a dynamic
stock market, one cannot say that the mar-
ket’s values are necessarily more accurate
than the accountants’ values, but one may
suggest that a low value of either should be
cause for concern by bank regulators.
Given our best measures of equity, we
must then face the central question of how to
determine how much equity is enough. From
the Modigliani–Miller argument, we may
infer that the total cost of credit from a bank
should be relatively insensitive to its fraction
of equity financing within some broad range
where its chance of bankruptcy is small, but
effective regulation requires that a bright
regulatory line must be drawn somewhere.
Of course, equity requirements can
only be defined in proportion to other ele-
ments of the bank’s corporate balance sheet.
Thus, formulas are generally constructed to
express equity requirements as a fraction of
the bank’s assets. However, there is some-
thing fundamentally misleading about put-
ting the question in these terms, because a
bank does not need equity for its assets; it
needs equity for its liabilities, to make them
credible to its creditors. In particular, banks
3
Accounting for regulatory purposes might appropri-
ately evaluate an asset differently when the asset that has
been assigned to a creditor as collateral for a loan. The
purpose of offering an asset as collateral in a secured loan
or repurchase agreement is to achieve better terms on the
loan by giving its creditors a claim on the asset ahead of
depositors, in the event of default. Regulators whose job
is to protect depositors might reasonably take the value of
the secured loan as the creditors’ estimate of the expected
value of the asset in the event of the bank’s failure.
Applying this standard to the valuation of pledged assets
in regulatory accounting would exclude from regulatory
capital any benefits that the bank might expect from such
transactions that put other creditors ahead of depositors.
need capital regulation where other corpo-
rations do not because banks issue deposits,
which are debts on the liability side of their
balance sheets. Of course, any formula that
specifies required equity for a bank as some
fraction X of its total assets is equivalent to
a formula that specifies required equity as a
fraction X
/(1−X) of its total debt liabilities.
Under either approach, however, the equity
requirement would depend on a calculation
either of total assets or of total debt liabilities.
Unfortunately, some accounting conven-
tions may allow closely linked assets and
liabilities to be netted out, so that their gross
amounts do not appear on either side of the
balance sheet. Consider, for example, two
banks that enter into an interest rate swap that
is equivalent to each bank selling the other a
five-year bond that has a value of $1 million
now, but with one bond paying a fixed inter-
est rate, and the other bond paying an inter-
est rate that will vary with short-term interest
rates in the future. Banks may use such swaps
to transfer interest-rate risks among them-
selves at a mutually agreeable price. But how
should these swaps be listed on the balance
sheet? A conservative accounting standard
might list each bank as having added $1 mil-
lion to both its assets and its debt liabilities
by the transaction. Under such accounting,
the swap would have no effect on either
bank’s equity value, but it would increase
each bank’s required equity by the factor X
(if we think in terms of assets) or X
/(1−X) (if
we think in terms of debt liabilities). On the
other hand, some might argue instead that
the assets and liabilities that each bank has
gotten in this swap are so similar (both are
five-year bonds with the same counterparty)
that they should simply be cancelled out on
the bank’s balance sheet, so that the swap
would have no effect on the required equity.
But such swaps do entail potential liabilities
that should not be ignored.
In fact, different accounting standards
make significantly different judgments on