Geithner almost gets something right

NYTimes reports:

The thrust of the plan is to have banks, particularly those deemed too big to fail, maintain larger capital cushions — a move bankers have traditionally opposed because it eats into their profits. The Treasury secretary, Timothy F. Geithner, is expected to outline the administration’s proposals Thursday in a letter to the finance ministers of the Group of 20 industrial and emerging nations, who are scheduled to meet in London this week.

The measures are still under discussion and, if adopted, probably would not take effect for years. But capital levels, once the domain of academics and policy specialists, have quickly become Topic A in banking circles and underpin the administration’s proposals for overhauling financial regulation. Compelling banks to hold more capital could radically reshape the industry.

What I like about this proposal:

1. Capital requirements are a real constraint on lending. Finally the Treasury is focused on something that matters.

2. It increases capital requirements as banks get larger. This weighs against banks becoming "too big to fail".

3. Excess leverage in the financial system drove the calamitous financial crises. Bank leverage is the size of the balance sheet vs. the site of paid in equity, ie. capital ratio.

Problems with this approach:

1. Capital requirements actually constrain lending. Do we really want to do this now?

2. Banks skirted capital requirements in the past, and will no doubt do so in the future. How about enforcing old rules? For example, a bank takes on some credit risk, but then "hedges" that with a CDS. This got them out of higher capital requirements in the past -- similar fraud will get them out of higher capital requirements in the future.

3. There is a more straightforward, and hard to game technique for having banks take credit quality seriously -- eliminate the secondary market. If you have to keep the loan on your book, you will care more about the recipient's ability to pay it back.

One final note: I'm disappointed that the Times decided to have the headline read: "White House to Propose Big Reserves at Banks". There is enough confusion out there between reserve requirements and capital requirements, this just makes that worse.