Should we Relax Capital Requirements?

Jim Surowiecki wants the Obama administration to formally relax capital requirements for banks; Ricardo Caballero wants them relaxed all the way to zero, which seems to me to be a form of nationalizing banks without taking any upside, a worst-of-both-worlds solution.

My feeling is that there already has been de facto, if not de jure, regulatory forebearance when it comes to capital requirements. Tangible common equity ratios have been falling dramatically, and a lot of the government’s new "equity" has come in the form of preferred stock which looks to the naked eye a lot like expensive debt. Plus, there seems to be a lot of don’t-ask-don’t-tell going on when it comes to dodgy assets which don’t need to be marked to market, especially in out-of-the-way areas like securities lending.

Would it be a good idea to relax capital requirements more formally and transparently? Yes, but only if some of the less formal and transparent ways of relaxing those requirements were closed off. And that I think would be hard. Historically, the don’t-ask-don’t-tell route has worked quite well: I’ve been told that virtually all banks would be insolvent in every recession if they had to mark all their assets to market daily.

On the other hand, I can’t ever recall seeing such a large gap between official measures of bank capital on the one hand (Citigroup claims its Tier 1 capital is 11.8%, up from 7.1% a year ago) and what the market actually believes, on the other. So maybe more transparency and more official forebearance really is the way to go.