How to Save the Financial System

As the world's bank regulators grapple with financial meltdown and try to prevent future crises, one of the few things uniting them is the belief that banks should be required to reserve more capital for a rainy day: more capital for credit risks, for liquidity risks, for operational and market risks—in short, more capital for anything that moves.

There are times when it makes sense to tie up capital throughout the banking system in the name of restraint. Spain raises reserve requirements in boom times to rein in irrational optimism. The Swiss plan something similar.

But imposing higher overall capital requirements isn't a panacea for the kinds of problems that caused the current crisis. By itself the strategy will do little to strengthen the financial system because it fails to take into account the differences among institutions and the different types of risk.

Increasing overall capital requirements could even reinforce an existing problem. Many new and smaller banks likely would find heftier reserve requirements a barrier to entry, leaving the field largely to the institutions that get costly bailouts because they are "too big to fail."

More important, simply raising capital requirements doesn't help to match risk-taking to risk capacity. At the heart of modern regulation is the erroneous view that risk is a quantifiable property of an asset. But risk isn't singular. There are credit, liquidity, and market risks, for instance—and different parts of the financial system have different capacities to hedge each. Thus, risk has as much to do with who is holding an asset as with what that asset is. The notion—popular in the U.S. Congress—that there are "safe" instruments to be promoted and "risky" ones to be banned is deceptive.

Instead, capital requirements need to be sensitive to an institution's natural ability to hedge the kinds of risks it holds.

Consider liquidity risk. Banks traditionally borrow from depositors who can snatch back their money overnight. Therefore, banks have a limited capacity to hold assets that can't be sold quickly without heavy discounting. So it makes sense to require extra capital to be set aside against any assets carrying this liquidity risk. Such risk is most safely held by the likes of pension funds and insurance companies, which have funding—longtime retirement savings accounts and premium payments—that generally cannot evaporate overnight.

Banks can, on the other hand, hedge effectively against credit risk by diversifying their lending and using information they have on potential borrowers. Pension funds are less able to offset credit risk. Their long-term funding doesn't help—the longer the period of investment, the more time there is for default.

The way to make the financial system safer is to encourage each type of risk to flow to an institution with the capacity to hedge it. Modern regulation did the opposite. By requiring banks to set aside more capital for credit risks than nonbanks must, regulators unintentionally encouraged banks to shift their credit risks to those who wanted the extra yield but had limited ability to hedge this type of risk. By not requiring banks to put aside capital for maturity mismatches, they encouraged banks to take on liquidity risks they couldn't offset. Moreover, by supporting mark-to-market asset valuations (which make institutions value holdings at their current price) and short-term solvency requirements, regulators discouraged insurers and pension funds from taking the very liquidity risks they are best suited for.

What is to be done? The objective of financial regulation should not be to hunt down risk and destroy it. Nor should it be to pile up sandbags of capital: That only leaves us with behemoth banks. We must instead differentiate institutions less by what they are called and more by how they are funded.

Capital requirements that encourage risks to flow to their "natural" holders will promote economic growth while making the system safer. Such reform will also bring in new players, lessening our dependence on a few banks that may appear well capitalized in a boom but are revealed, in a bust, to have little capacity for the risk they are holding.

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