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Goodhart's Law states that any statistical regularity or economic measure that becomes a target for the purpose of policy will lose the information content that qualifies it to play that role. I've been thinking about that a lot lately in preparation for tomorrow's Complements to Basel conference at the Bank of England, a joint production of the LSE Financial Markets Group and the Centre for Central Banking Studies. The conference will be chaired by Charles Goodhart himself.
It seems to me that bank capital has become a victim of capital adequacy regulation, in a further proof of Goodhart's Law.
For twenty-five years the Basel Capital Accords have made capital the focus of prudential supervision policy. Capital during this period has become so distorted and debased by bank managements' determination to game the regulations - and enrich themselves - that it is almost meaningless as a measure of the adequacy of a bank's financial reserves or the competence of bank management. It is worth noting in this context that profits which are not required as capital reserves go into the bonus pool, giving management a direct pecuniary interest in minimising liquid capital held as reserves. Most of the banks that have failed in this financial crisis had surplus regulatory capital right up to the day of their collapse - at least according to their internal calculations.
Capital is meant to be held as highly liquid, marketable assets, that can be sold to raise funds in a hurry to support the confidence of depositors and other creditors. It must be in assets that the financial world would recognise as having established value even under stress conditions if confidence is to be preserved that a bank will withstand the crisis. Yield hungry managements, determined to hold as little capital as possible, and that in higher yielding, less liquid assets, have made a mockery of the whole concept of capital as a financial reserve. When it becomes transparently clear that the assets they hold have minimal value and less liquidity, it is governments and central banks that are expected to pick up the slack at taxpayers and savers' expense.
Was RMBS liquid and marketable under stress? Nope. (50 per cent risk-weight under Basel.) Was interbank debt liquid and marketable under stress? Nope. (20 per cent risk-weight under Basel.) How about those Greek or Portugese government bonds? Nope. (Zero risk-weight under Basel.) Don't even get me started on credit default swaps, which only have value months later, and then only if an ISDA committee determines a default and the debt auction determining the pay out isn't rigged.
In consequence of banks being undercapitalised and illiquid under stress, governments have had to spend billions in bailouts, eroding their own credit standing and the very bonds their banks hold as capital at the same time, and central banks have "quantitatively eased" their currencies toward debasement.
No one looking at bank capital today recognises a liquid reserve of marketable assets. Instead we see models which depict a show of compliance with 4,000 pages of standardised complexity. Where the purpose of capital was once to shore up the confidence of depositors; its purpose now is to minimally satisfy supervisors.
Whatever bank capital once was, and whatever its purpose once was, has been massively eroded by capital becoming the focus of globalised, standardised prudential supervision.
Goodhart's Law confirms the irony that Basel Capital Accords have left banks woefully undercapitalised. We are all poorer for the lesson.
It seems to me that bank capital has become a victim of capital adequacy regulation, in a further proof of Goodhart's Law.
For twenty-five years the Basel Capital Accords have made capital the focus of prudential supervision policy. Capital during this period has become so distorted and debased by bank managements' determination to game the regulations - and enrich themselves - that it is almost meaningless as a measure of the adequacy of a bank's financial reserves or the competence of bank management. It is worth noting in this context that profits which are not required as capital reserves go into the bonus pool, giving management a direct pecuniary interest in minimising liquid capital held as reserves. Most of the banks that have failed in this financial crisis had surplus regulatory capital right up to the day of their collapse - at least according to their internal calculations.
Capital is meant to be held as highly liquid, marketable assets, that can be sold to raise funds in a hurry to support the confidence of depositors and other creditors. It must be in assets that the financial world would recognise as having established value even under stress conditions if confidence is to be preserved that a bank will withstand the crisis. Yield hungry managements, determined to hold as little capital as possible, and that in higher yielding, less liquid assets, have made a mockery of the whole concept of capital as a financial reserve. When it becomes transparently clear that the assets they hold have minimal value and less liquidity, it is governments and central banks that are expected to pick up the slack at taxpayers and savers' expense.
Was RMBS liquid and marketable under stress? Nope. (50 per cent risk-weight under Basel.) Was interbank debt liquid and marketable under stress? Nope. (20 per cent risk-weight under Basel.) How about those Greek or Portugese government bonds? Nope. (Zero risk-weight under Basel.) Don't even get me started on credit default swaps, which only have value months later, and then only if an ISDA committee determines a default and the debt auction determining the pay out isn't rigged.
In consequence of banks being undercapitalised and illiquid under stress, governments have had to spend billions in bailouts, eroding their own credit standing and the very bonds their banks hold as capital at the same time, and central banks have "quantitatively eased" their currencies toward debasement.
No one looking at bank capital today recognises a liquid reserve of marketable assets. Instead we see models which depict a show of compliance with 4,000 pages of standardised complexity. Where the purpose of capital was once to shore up the confidence of depositors; its purpose now is to minimally satisfy supervisors.
Whatever bank capital once was, and whatever its purpose once was, has been massively eroded by capital becoming the focus of globalised, standardised prudential supervision.
Goodhart's Law confirms the irony that Basel Capital Accords have left banks woefully undercapitalised. We are all poorer for the lesson.
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