Not Lack Of Capital. Lack Of Liquidity.

Andrew Atkeson and William Simon seem to believe that the recent volatility in bank stocks that they dread so can be curbed if regulators display "forceful leadership" and insist that banks lay in even more capital than they already have.

Sorry, the world doesn't work that way. Here's a news flash for all the erstwhile financial reformers who seem to think simply adding more capital is some sort of cure-all for the system's ills: it's not. Near-term financial panics don't happen because of worries banks won't have enough capital to absorb future credit losses. (Not that that's not a legitimate concern. During times of non-panic, it's usually investors' single biggest concern.) Rather, panics happen because of worries banks won't have enough liquidity to open their doors the next day. When Lehman Brothers failed, for instance, its core Tier 1 capital ratio was positively plump at 11%. Would the company have imploded anyway if that number were 20%, instead? Thirty percent? Almost certainly, yes. Here's why: Lehman depended on overnight funding to fund itself. By the time things came to a head, no capital level would have been high enough to calm the fears of the company's jittery liquidity providers, each of whom was by then was highly addled, and less concerned about Lehman's eventual credit losses than it was determined that it not end up as Lehman's last source of funding. A run on the bank, in other words.?

That's why all this ginned-up outrage over which banks lined up at the Fed's discount window, and how much they took, is bogus. If the participants in a financial system become so panicky that they won't lend to each other��and that happens from time to time��the system will freeze and collapse absent provision of liquidity by a lender of last resort. That's what central banks are. If the Fed hadn't been around to open its window in 2008, the result would have been a calamity. Would-be reformers who emphasize added capital and nothing else are offering a plan ! that won 't likely help much during the next crunch.

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