#regulators

There is one perennial, overlooked, and devastating irony in the vast body of bank capital and liquidity regulation:  the better a bank’s liquidity score, the less regulatory capital it has.  Although liquidity and capital are inexorably linked when it comes to preserving bank solvency, the need to comply with two contradictory standards forces banks to change their business model to meet both ends in the middle at considerable cost to profitability and long-term franchise value.  This is of course a major threat to solvency of which bank regulators are either blissfully unaware or, worse, heedless.  Federal banking agencies have stoutly refused to undertake the essential cumulative-impact analysis we’ve fruitlessly urged on them most recently in Congressional testimony.  A new Federal Reserve Bank of New York study shows not just why they should judge rules by sum-total impact, but also how they could do so and thereby have a much better sense of which banks might actually go broke before they do.

I refer you to the full FRB-NY paper for details.  It crafts an economic-capital construct calculated by netting the net present value of financeable assets versus par liabilities as a baseline measure which can then be tested under various stress scenarios that start with illiquidity and end in insolvency and vice versa.  This leads to a robust measure of survivability that combines the impact of credit risk, liquidity, and the real-world market conditions current rules ignore.  In essence, economic capital is derived from the hard-nosed, real-time factors that wise …