Bank Reserves: Rajan finds Rebellious Sweet Potato

Today I get into Garíon territory, and on top I start with an “exposé”: his colleague from Chicago Raghuram Rajan reads “Nothing is Free”. Okay, it’s a joke, that you have your heart and you also want to be read, even if it’s using tabloid tactics. It turns out that yesterday, in the Financial Times, Rajan wrote an article that is related to the theory I expressed in a post in early September: the regulations tend to fail (in that case I was referring to the Sarkozy initiative to limit the “bonus” of the bankers) beca use it is difficult to find a sufficiently complete contract for those affected, who have more powerful incentives than the regulator, to find a hole in the law that allows them to go around the blockade. The sweet potato came to account for a story of my father from our post-civil war: when the potato had the regulated price, the markets were emptied of potatoes and filled with sweet potatoes.

Bank Reserves Rajan finds Rebellious Sweet Potato

The star regulation of the G-20 to avoid another crisis like the current one is to increase the capital requirements to the banks. But it seems to Rajan that American banks, and other countries with well-developed financial sectors, will skip regulation, which consumes capital with a very high opportunity cost. They will simply pass funds from regulated activities to less regulated activities, as they have done in recent years with their structured investment vehicles.

Rajan proposes “contingent capital” as an alternative. Something like a line of credit, but better, you’ll see. Rajan’s argument is that this capital will be cheap because it will be requested when things go well and this will not generate arbitrage. The version that Rajan likes is that of the Squam Lake Group, which consists of bonds convertible into “equity” when two conditions are met: aggregate financial conditions are bad, measured in an objective and automatic manner, and the bank’s capital ratio is less than a certain level.

At the moment I cannot think of a clear objection to this mechanism. But it is important to note that financial conditions deteriorated so rapidly in our recession that Rajan’s first condition would not work if we had to wait for the appearance of periodic indicators. Perhaps the decision to “shoot” these clauses of the debt contracts, which should be armored against the more than probable visit to the courts of the debt owners, could be left to the corresponding Central Bank.

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