Prof. Ricardo Caballero of MIT offers a simple solution. Instead of requiring banks to raise capital to meet the demands of extreme stress-test scenarios, the government should offer to sell banks insurance against these potential risks. That would go a long way to minimizing the negative feedback loop that has been at work in recent months. Excerpts:
A bank should be required to have as much capital as needed for the central scenario. If aggregate conditions are worse than expected, the government should cover the shortage of capital without equity compensation. If conditions are better than expected, the government should be paid a fee that compensates it for the insurance it provided. The government should charge fairly for this insurance, using the same probabilities it assigns to the different scenarios used in the stress tests. A weak bank needs to contract for more insurance than a strong bank.
It makes no sense that the aggregate risk remains on the most leveraged institutions of the system – which is precisely what got us into this mess. Instead, the way to solve this mismatch is to make fair insurance available to the banks rather than to force them to deleverage at great cost for the entire economy.
HT: Don Luskin