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December 03, 2013

"You give me a capital requirement, I’ll give you a derivative to skirt it"

Cathy O'Neil, the "Mathbabe," suspects it's true. And history seems to support her.

Admati and Hellwig’s suggestion is to raise capital requirements to much higher levels than we currently have.

Here’s the thing though, and it’s really a question for you readers. How do derivatives show up on the balance sheet exactly, and what prevents me from building a derivative that avoids adding to my capital requirement but which adds risk to my portfolio?


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Patrick R. Sullivan

Not so fast, says Charles Calomiris;

'Admati and Hellwig assert that accomplishing a credible increase in the proportion of bank equity capital is a simple matter of increasing minimum regulatory requirements for the ratio of the book value of equity relative to assets. Would that it were so simple, but it is not; increasing the book equity ratio in an accounting sense does not necessarily increase true bank capital ratios, as I argue in my recent work (Calomiris 2013). Bank balance sheets do not capture many of the economic losses that banks may incur. Also, accounting practices can disguise the magnitude of loan losses, and regulators eager to avoid credit crunches are often complicit in doing so. The result is that banks’ true equity ratios can be much lower than their book values indicate. Furthermore, banks’ risk choices matter, not just their equity. Both the Basel approach to risk weighting of assets and the simpler approach the authors advocate (that would abandon all risk weighting in favour of a simple equity-to-assets requirement) have a common flaw – they encourage banks to pursue hidden increases in asset risk.'

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