raise more capital (back to 6 percent or more) or call back its loans from the $100 to a level that matches with the capital-to-asset ratio. All that the regulators are interested in is raising new capital or shrinking assets to restore individual bank soundness. Macroprudential regulation, however, deals with systemic risk or soundness of the entire system. Each bank, by acting in its own selfinterest, may jeopardize the entire system. If every bank in the economy is faced with the problem of shrinking assets—say, resulting from a common shock—the whole economy will suffer for want of credit. The costs to society when many banks shrink their assets simultaneously are credit crunches and fire sales of assets. Individual banks cannot raise new capital to correct the situation because their balance sheets are impaired and raising new capital in the market is expensive or difficult—especially during bad times. Also, banks do not keep capital buffers during good times because they are interested in maximizing lending and, therefore, profits. Keeping additional capital voluntarily is not in the interest of the individual bank.
What Should Be the “Field of Vision” of the Financial Regulators? One macroprudential tool is for regulators to impose a higher capital-toasset ratio in good times, compared with the ratio that is imposed by the market in bad times. During bad times, markets place a premium on “wobbly” banks. A second tool is the quality of capital. For example, banks A and B both begin with total assets of $100 each and total capital of $6 each. But A’s capital is composed entirely of equity, where B has $2 of equity and $4 of preferred stock. Now suppose both banks lose $3. In an effort to avoid shrinking their assets, they would like to raise new capital. Suppose they do so by trying to issue equity. This will be harder for Bank B, whose entire preexisting equity layer has been wiped out and whose preferred stock is, as a result, now trading at a steep discount to its face value (for any new equity that B brings in will largely serve to bail out the position of its more senior preferred investors). Common equity is desirable as such. A third possible tool is to promptly take corrective action. For example, bring the capital-to-asset ratio back to the required ratio, as discussed above. A fourth policy could be to resort to contingent capital where a debt is automatically converted to equity once a certain threshold of capitalto-asset ratio is not met (as Lloyd’s insurance company did in 2009). The Role of Macroprudential Regulations
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