“REGULATORY CAPTURE BY SOPHISTICATION”. Professor Johnson recommends and links to a very interesting paper by Martin Hellwig which analyzes attempts after the Financial Crisis to reform the capital regulation of banks. The paper urges raising capital requirements “very substantially” and cutting back on using weights based on estimated risks. The changes in banking regulation since the 1990’s were based on using estimates of the riskiness of bank assets as determined by bank models. The result was that large banks at the time of the Crisis had equity amounting to only 2% of their balance sheets. In a section entitled “Regulatory Capture by Sophistication: A Brief History of Capital Regulation”, Hellwig says that the regulatory changes were approved because the regulatory community was overly impressed with the recently developed bank models. The result is what is apparently an industry catch phrase—“economizing on equity.” If a small margin is multiplied by a factor of 40, even small margins can lead to substantial returns on equity.

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