Of course, as central bank governor Tetangco points out, the reform agenda is not yet fully implemented. But the exposures of Morgan Stanley and Goldman Sachs, at least, suggest that the banks haven’t done much to reduce them on their own, and the regulators haven’t done much to encourage them to do so.
Moreover, D’Arista, a former staff economist for the US Congress who is now retired from teaching, contends the problem is compounded by regulators’ reliance on bank capital instead of cash reserves to cushion losses. She notes that banks’ capital cannot help but rise and fall together with their assets, making banks more fragile than they were when the Federal Reserve required them to hold cash equal to 10% of their assets. Those reserve requirements were gradually eliminated with the advent of the first Basel agreement in 1985.
“Putting capital in place was the worst thing we could have done,” D’Arista says. “Systemically, it’s a disaster.” She and Epstein aren’t alone in worrying about the correlations among bank assets. Co-Pierre Georg, a lecturer in the school of economics at the University of Cape Town who has written extensively on the topic, says bank interconnectedness is very “stubborn,” perhaps because banks believe the fact that other banks are doing business with them signals that they are healthy. But as a result, he says, they tend to hold many of the same assets.
Georg says the problem may not be solvable through regulation, at least as currently conceived. He observes that Basel III’s continued emphasis on risk weightings, under which more capital must be held against assets that are deemed riskier and less against those deemed less risky, “creates an incentive to become more correlated.” That is because banks will gravitate toward assets that allow them to minimize their capital, including sovereign bonds, derivatives and interbank loans.
Georg asserts, “Regulation has not adequately addressed the issue” of correlation. And although he concedes that banks’ improved capital position may help them better withstand another meltdown, he points out: “Only the next crisis will tell for sure.”