by Viral V Acharya and Arvind Krishnamurthy
While the House and the Senate Bills empower the regulators to impose greater capital requirements on banks and systemically important institutions, they provide little guidance on how we might have to improve design of capital requirements going forward. In particular, how should we deal with fail-safe assets such as AAA-rated tranches of mortgage-backed securities and liabilities such as overnight secured borrowing ("repos") which were not capitalized, were held in large quantities, and ended up bringing down the entire financial sector through losses and runs? The Financial Times oped at the link below (joint with Arvind Krishnamurthy) argues that the entire risk of these "too safe to fail" transactions is systemic in nature, and hence financial sector has incentives to essentially ignore the risk, unless we reform capital requirements to be higher for these transactions. This is in fact the opposite of how (Basel) capital requirements are currently designed, which is to in fact give higher incentives for such transactions.
Financial Times Market Insight column
Why bankers must bear the risk of "too safe to fail" assets.
March 18, 2010