Fictional bank capital

Why our Fundamental Approach to Banking Regulation is Inherently Unsound

Our current approach to banking regulation exposes us to recurrent, intensifying financial crises. The good news is that because we reached an all time low in Basel II, Basel III almost has to be an improvement. The bad news is that Basel III has not reexamined the fundamental assumptions underlying the Basel process. As a result, Basel III will be a variant on the common ineffective theme of banking regulation designed by economists and the industry. ...

The fundamental disconnect with making capital requirements the pillar of banking regulation is that “capital”, “net worth”, and “equity” are accounting concepts. They have no meaning outside of accounting. Worse, they are all residual accounting concepts. Accountants do not, and cannot, count a modern bank’s “capital.” They determine assets and subtract liabilities to determine capital. The implication of that is that the accuracy of reported “capital” depends on the accuracy of the valuation of every asset and liability. That means that capital is not only an accounting concept, but the accounting concept most subject to error. For a large bank, there are literally tens of thousands of ways to use accounting to distort reported capital by enormous amounts. Beyond the obvious – understate liabilities and overstate asset values – banks are the perfect vehicles to self-fund “capital.”