Bankruptcy

Relaxation of Regulatory Capital Rules

By Adam Levitin

As I noted in an earlier blog, the Fed seems to be knocking down every firewall that exists in banking regulation in an effort to stanch the current crisis. The danger, of course, is that by demolishing prudential firewalls, the crisis could grow even bigger. The latest casualty: accounting standards. Banks will now be permitted to count goodwill toward their Tier I capital requirements.

Goodwill is a very problematic asset--it doesn't have much (if any) liquidation value and can't be sold by itself. No one will lend against goodwill. If capital requirements are really about ensuring that there is a solid fundamental core of assets backing lending operations, counting goodwill is quite questionable. The most troubling part of this is that we've been here before--in the S&L crisis, when the Federal Home Loan Bank Board (now OTS) permitted thrifts to count goodwill toward regulatory capital. The results weren't pretty, as counting goodwill toward capital masked institutional insolvency and permitted thrifts to get even more leveraged relative to real assets. (See U.S. v. Winstar, 518 U.S. 839 (1996) for a concise discussion of the goodwill problem with thrift accounting).

One of the justifications of the government's nationalization of Fannie/Freddie (for that is what it is, effectively) and functional purchase of AIG was that federal regulators wanted to be in control of these institutions to prevent them from doubling down on their bets and taking even bigger risks in an effort to regain profitability. The Fed/Treasury feared that the managers of these firms had little to lose so they would engage in overly risky gambles, which would only exacerbate the crisis. While the relaxing of the regulatory capital rules is meant to enable healthier institutions to take on troubled ones, but it runs the danger of setting up exactly the situation that the Fed/Treasury were worried about with Fannie, Freddie, and AIG.

These are not days for consistent policy making, and banking regulation is meant to avoid crises, not solve them, but if Treasury and the Fed can't contain the crisis now, they've removed some of the safeguards that could prevent it from getting even bigger later.

Full post as published by Credit Slips on September 17, 2008 (boomark / email).