The Mystery of Capital « The Baseline Scenario

The Mystery of Capital « The Baseline Scenario: "“Capital does not exist in the world. It is not accessible to the senses. When we claim a bank or any other firm has so much ‘capital’ we are modeling its assets and liabilities and contingent positions and coming up with a number. Unfortunately, there is not one uniquely ‘true’ model of bank capital. Even hewing to GAAP and all regulatory requirements, thousands of estimates and arbitrary choices must be made to compute the capital position of a modern bank. There is a broad, multidimensional ‘space’ of defensible models by which capital might be computed. When we ‘measure’ capital, we select a model and then compute. If we were to randomly select among potential models (even weighted by regulatory acceptability, so that a compliant model is much more likely than an iffy one), we would generate a probability distribution of capital values. That distribution would be very broad, so that for large, complex banks negative values would be moderately probable, as would the highly positive values that actually get reported. . . . Given the heterogeneity of real-world arrangements, no ‘one-size-fits-all’ model can be legislated or regulated to ensure a consistent capital measure. We cannot have both free-form, ‘innovative’ banks and meaningful measures of regulatory capital.”"