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More Stress Tests, Please

Although higher capital requirements do seem like a no-brainer, Andrew Kuritzkes and Hal Scott offer some words of caution in the FT:

The five largest US financial institutions subject to Basel capital rules that either failed or were forced into government-assisted mergers in 2008 – Bear Stearns, Washington Mutual, Lehman Brothers, Wachovia and Merrill Lynch – had regulatory capital ratios ranging from 12.3 per cent to 16.1 per cent as of their last quarterly disclosures before they were effectively shut down. The capital levels of these five banks were between 50 per cent and 100 per cent above the minimums and 23 per cent to 61 per cent higher than the well-capitalised standard.

Even though Kuritzkes and Scott don't mention the possibility that a different mix of capital might be more effective in cushioning against distress, they do come up with an interesting idea: more stress tests.

They point to the fact that banks were able to raise $87 billion in capital after the stress tests revealed information about their health. In a sense, more testing would mean that the much-needed systemic risk regulator would embrace the role of an activist hedge fund manager like Bill Ackman or David Einhorn, both of whom did their own stress tests on Lehman, Ambac, and MBIA -- and turned out to be right about their woeful prospects. The presence of such a regulator could be just as important as higher capital requirements.

A new paper by Robert Merton, Andrew Lo, and Amir Khandani makes the same point in a different way. They find that the timing of three trends -- rising home prices, low rates, and easy refinancing -- combined to "vastly" increase the amount of systemic risk. On its own, any one of these trends is probably a good thing, but

when they occur simultaneously, as they did over the past decade, they impose an unintentional synchronization of homeowner leverage...If refinancing-facilitated homeowner-equity extraction is sufficiently widespread---as it was during the years leading up to the peak of the U.S. residential real-estate market---the inadvertent coordination of leverage during a market rise implies higher correlation of defaults during a market drop.

What's worse is that the U.S. didn't have the regulatory setup to identify this sort of complex risk:

Currently, no single regulatory body is responsible for monitoring the three refinancing- ratchet conditions; in fact, on occasion, each of these conditions has been associated with the policy objectives of one part of government or another. Therefore, it is difficult to imagine any existing regulatory agency raising red flags over any of these conditions.