A sound case can be made for pro-cyclical capital requirements, that is, lowering the amount of capital that banks must hold relative to assets in bad times and increasing it in good ones. Indeed, well designed pro-cyclical rules lean against the banks’ propensity to overdo on lending to the point where they blow themselves up. And the fact is that regulators relax capital requirements (aka regulatory forebearance) when the banking system looks wobbly, so make a virtue out of necessity by making equity requirements more stringent in upturns.
So this regulators cutting banks some slack at times like this is predictable, and the measure described in the New York Times is no surprise:
With little notice, regulators at four agencies that oversee the nation’s banks and savings associations on Monday and Tuesday proposed a significant change in accounting rules to bolster banks and encourage widespread industry consolidation by making them more attractive to prospective purchasers. The regulators and the Bush administration have decided to resort to further loosening of the accounting rules to try to get the industry through problems that some experts have attributed in large part to years of deregulation…….The action by the four banking agencies provides more favorable accounting treatment of so-called goodwill, an intangible asset that reflects the difference between the market value and selling price of a bank. The move is similar to a step taken in the midst of the savings-and-loan crisis that helped many institutions in the short run. Over the longer term, that decision increased the overall costs of the bailout after the government took away the goodwill benefits. Under the proposal issued this week, the regulators would permit buyers of banks and thrifts to count some of the goodwill toward meeting their regulatory capital requirements.
But is this way of going about it wise? Adam Levitin at Credit Slips thinks not:
Goodwill is a very problematic asset–it doesn’t have much (if any) liquidation value and can’t be sold by itself. No one will lend against goodwill. If capital requirements are really about ensuring that there is a solid fundamental core of assets backing lending operations, counting goodwill is quite questionable. The most troubling part of this is that we’ve been here before–in the S&L crisis, when the Federal Home Loan Bank Board (now OTS) permitted thrifts to count goodwill toward regulatory capital. The results weren’t pretty, as counting goodwill toward capital masked institutional insolvency and permitted thrifts to get even more leveraged relative to real assets. (See U.S. v. Winstar, 518 U.S. 839 (1996) for a concise discussion of the goodwill problem with thrift accounting).One of the justifications of the government’s nationalization of Fannie/Freddie (for that is what it is, effectively) and functional purchase of AIG was that federal regulators wanted to be in control of these institutions to prevent them from doubling down on their bets and taking even bigger risks in an effort to regain profitability. The Fed/Treasury feared that the managers of these firms had little to lose so they would engage in overly risky gambles, which would only exacerbate the crisis. While the relaxing of the regulatory capital rules is meant to enable healthier institutions to take on troubled ones, but it runs the danger of setting up exactly the situation that the Fed/Treasury were worried about with Fannie, Freddie, and AIG.
These are not days for consistent policy making, and banking regulation is meant to avoid crises, not solve them, but if Treasury and the Fed can’t contain the crisis now, they’ve removed some of the safeguards that could prevent it from getting even bigger later.
JPP 
Posts
http://blogs.ft.com/maverecon/2008/09/the-end-of-american-capitalism-as-we-knew-it/#more-300
I would invite someone to comment on this column in the Financial Times; the author says that the current nationalization of the lynchpins of the financial system should be made permanent. That way, we avoid the incentives for high risk that created the situation we are in now, and in times of duress, there is no uncertainty, neither on the part of goverment about which company to save and which to let fail, nor on the part of investors about which institutions are truly failsafe.
Makes a lot of sense to me.