Regulatory Rules Fall Short

Christopher Cox is rightly concerned that the brokerage houses he oversees could be savaged by liquidity crises, as Bear Stearns was. The Securities and Exchange Commission chairman thinks it makes sense to reassess how regulators deal with the risk that firms' access to crucial everyday cash dries up, perhaps even by extending capital adequacy rules to deal explicitly with this risk. Unfortunately, that probably wouldn't work. It sounds reasonable. Regulators have expanded the rules governing the capital banks set aside to cover an ever-greater variety of perils. They originally told banks to base capital reserves on how much credit risk they had. Then they added risks associated with market prices. The latest version of the rules added operational risks -- the possibility of loss stemming from human or logistical snafus. So why not bolt on liquidity risk and require firms to raise capital when trading counterparties or lenders get skittish about dealing with them? One problem is that liquidity can evaporate in the blink of an eye. In congressional testimony Thursday, Mr. Cox noted that Bear's cash pool fell from more than $12 billion to $2 billion in a single day. It usually takes weeks or months to raise new capital. Also, forcing firms to raise capital would raise red flags that could accelerate a crisis -- even if a firm in the midst of a cash crunch could persuade investors to pony up capital in the first place. Firms might try establishing contingent capital facilities before disaster strikes so they could draw on them when needed. But that would be expensive, eating into and perhaps obliterating earnings. Mr. Cox and his confreres at the Fed and the U.S. Treasury would clearly prefer to avoid having to cobble together responses like the one that rescued Bear. But forcing firms to raise capital as liquidity declines isn't practical. The sentiment governing bank runs is too volatile to be tamed by the blunt instrument of regulatory capital rules.