Why there can’t be a cap on bank capital ratios

By Felix Salmon
November 5, 2009
Nassim Taleb's new paper, co-written with Charles Tapiero. And I fear that the paper's main point is hidden in a blizzard of equations:

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I don’t understand much of the mathematics in Nassim Taleb’s new paper, co-written with Charles Tapiero. But still I fear that the paper’s main point is hidden in a blizzard of equations:

taleb1.tiff

taleb2.tiff

The point here is that the risk to the taxpayer associated with any given bank grows exponentially with that bank’s size. Ceteris paribus, a bank with $500 billion in assets is a lot riskier than a bank with $400 billion in assets, not only 25% riskier.

Treasury seems to consider too-big-to-fail to be a binary thing: either you are, or you’re not, and if you are, then you’ll have to get by with higher capital requirements. But if that kind of a scheme is implemented, then it automatically creates a strong incentive for any too-big-to-fail bank to grow, and grow fast. The bigger that a TBTF bank gets, the more moral hazard can be palmed off onto the taxpayer, while the bank’s own capital ratios don’t have to rise at all.

Treasury I think should consider a scheme where capital ratios rise steadily with the size, risk, and interconnectedness of financial institutions, rather than simply falling into one of two buckets. And there should be no cap on how high those capital ratios can get. If such a cap is put in place, then every big bank will simply be given an incentive to blow straight past it.

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