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.S.EmergingYear Ending (U.S.), % (U.S.), % Markets, % Markets, %12/31/2004 83.3 93.8 72.1 61.912/31/2008 95.7 97.9 92.8 83.9Source: Bianco Research L.L.C.swaps allow investors to hedge against the credit risk of a bond, as distinctfrom its interest rate risk.However, as explained in Chapter 4, they canbankrupt an insurer if the risks of these swaps are not fully understood.Both the globalization of financial markets and the fast pace of finan-cial innovation are facilitated by the high speed and low costs of financialtrading.For example, hedge funds are capable of doing business from anytax haven, since executing trades between small island and money centersis so cheap.For the same reason, the sponsor of a new product can easilyfind some jurisdiction that will allow that product to grow rapidly withlittle or no consideration of its downside risk.Each Country Has an Interest in Its Own Anticyclical MeasuresThe United States and other countries with well-developed capitalmarkets each have their own interest in adopting anticyclical measures.If another global financial crisis occurs, a country with overcapitalizedbanks will do better than a country whose banks have the standardlevels of capital.In other words, the adoption of anticyclical measuresin every country with an advanced economy makes sense without aninternational agreement on such measures.The current capital requirements for banks in most countries areprocyclical.In good times, as the earnings of banks and the value of bankassets rise, so does their capital.With more capital, they can make moreloans and buy more securities.For example, if a bank has a 15 to 1 lever-age limit on its assets relative to its capital, it can use $1 million in capitalto acquire $15 million in assets.If its capital increases to $2 million due toprofits, it can double its assets to $30 million in order to seek even higherprofits. 340 t oo bi g t o s a ve ?On the other hand, a high leverage ratio creates a downward spiralin bad times.If the bank goes from $2 million to $400,000 in capitalbecause of current losses, it usually cannot raise new capital from thisweakened position.Instead, the bank must reduce its $30 million inassets quickly to $6 million to maintain its 15 to 1 leverage ratio ($6 mil-lion to $400,000 15 to 1).When many banks dump assets at the sametime, the value of most loans and securities plummet, leading to morelosses at banks and more dumping of assets.To dampen the effects of business cycles on the financialsystem, bank regulators should require banks and other finan-cial institutions to build up excess capital in good times sothey have bigger capital cushions in bad times.These capitalcushions should be especially large for financial institutions that seemlikely to be deemed too big to fail, because they will be supported bythe national government if they run short of capital.Similarly, bank regulators should require financial institu-tions to build up excess reserves for loan losses in good times,so these reserves can be drawn upon in bad times.However, secu-rities regulators have traditionally been concerned about excess loan lossreserves at financial institutions.They are concerned that banks wouldcover up their losses by quietly drawing down these reserves to absorblosses in bad times.The solution: Require banks to report excessreserves separately from normal reserves on their financial state-ments.Then investors could see clearly whether and when bankswere depleting their excess reserves to cover current losses.Anticyclical measures like these have been implemented in Spainwith some degree of success.They also have been supported by theFinancial Stability Forum, an international group of bank regulators, 58as well as by the Obama Administration.59 Although the Forum has noenforcement powers, it is working with the Basel committee of bankingexperts from across the world.By the end of 2009, the Basel committeeplans to make anticyclical proposals, which are likely to be adopted bythe many countries now following Basel II.(See Chapter 6.)Unfortunately, the Financial Stability Forum supported the newaccounting rule allowing European banks to shift their assets from thetrading category subject to fair value accounting (FMV) to the held-to-maturity category subject to historical cost accounting.But this was The International Implications of the Financial Crisis 341mainly a political decision, designed to mask losses of European banks intheir trading portfolios.As a result of such accounting shifts, Europeanbanks increased their profits by $29 billion in 2008.60The Forum s position is consistent with the stance of many bank-ers and politicians, who want FMV accounting suspended in favor ofhistorical cost accounting in this financial crisis.However, FMV hasalready been modifi ed to allow bankers to value illiquid assets on thebasis of internal models rather than market prices.(See Chapter 12.)No country should go further and suspend FMV accountingbecause that would obscure the fi nancial position of banks andthereby delay remedial responses.Such delayed responses hap-pened in Japan during the lost decade of the 1990s, and in the UnitedStates during the savings and loan crisis in the 1980s.Suspension ofFMV accounting would also undermine the confi dence of investors inthe financial statements of banks.A better approach would be to provide disclosures that areas accurate as possible, but unlink fi nancial accounting meth-ods from bank capital requirements, as explained in Chapter 12.Such unlinking already occurs in the category of securities held for sale,where market losses or gains do not alter a bank s regulatory capital.Such unlinking could be extended to other asset categories as long asthese extensions were fully disclosed.Under this approach, banks couldprovide investors with up-to-date financial statements, without depletingtheir regulatory capital.The Potential for International FinancialRegulation Is LimitedBesides adopting these anticyclical measures, regulators face formidablechallenges in trying to prevent financial booms and busts.The low costand high speed of executing transactions allow market participants toramp up quickly the volume of a new financial product
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