The ice on the roads creates a risk of the car going out of control. Unanticipated volatility in the market creates the risk of a bank being insolvent.
To manage the risk of your car going out of control, you choose a safe speed.
To manage the risk of a bank becoming insolvent, it chooses an amount of capital to keep in reserve.
I seriously doubt you take exception with any aspect of the analogy so far...
A speed limit sign suggests a speed that is safe to drive. However like any regulation it is only an imperfect estimate. Yet people seem to drive at that speed under adverse weather conditions completely irrationally.
A reserve requirement suggests an amount of reserve capital that is safe for operation of a bank. However like any regulation it is an imperfect estimate. Few banks carry reserves in excess of those set by the requirement.
These are completely identical scenarios. In each case, humans cluster around the regulation without exercising independent judgment. Drivers slide off of the road all the time, and a bit of recent price volatility sent many banks into insolvency.
Your example about the UK is noteworthy but I would argue that due to the dominance of US banks (and US regulations) in financial markets, UK banks are inclined to mirror US policies in order to remain competitive with US banks. Analogously, a Russian firm may adopt some US accounting practices if it wishes to attract investment from the US.
There are two factors: The first is the way that the bar is set by the regulation in the first place. T
he second is the grouping/incentive effect. If your competitor has too few reserves then you are at a disadvantage for not copying that behavior unless the economy crashes (such that your competitor goes out of business and you don't).
>A reserve requirement suggests an amount of reserve capital that is safe for operation of a bank.
In one case we have members of the public who have passed a driving test. In the other, we have the foremost experts in the field, using the latest theories of risk, working with millions of dollars of modelling and statistical equipment, with their jobs on the line. For what good reason would a single one of them look at the reserve rate and say "Although the government doesn't claim that this is a safe rate for banks to operate at, but instead sets it completely arbitrarily, and admits to the fact that it's totally arbitrary, and has not changed this rate in several decades because it is an obsolete tool of monetary policy, I am nevertheless going to take it to 'suggest' a safe level of reserves, totally ignore all of my models and education, and just pick that number on a completely irrational basis."
That just makes my point even better. Experts set safe speed limits for non-experts to follow. Minimum reserves are set arbitrarily and experts that decide actual reserve levels will not pay them any attention.
To manage the risk of your car going out of control, you choose a safe speed.
To manage the risk of a bank becoming insolvent, it chooses an amount of capital to keep in reserve.
I seriously doubt you take exception with any aspect of the analogy so far...
A speed limit sign suggests a speed that is safe to drive. However like any regulation it is only an imperfect estimate. Yet people seem to drive at that speed under adverse weather conditions completely irrationally.
A reserve requirement suggests an amount of reserve capital that is safe for operation of a bank. However like any regulation it is an imperfect estimate. Few banks carry reserves in excess of those set by the requirement.
These are completely identical scenarios. In each case, humans cluster around the regulation without exercising independent judgment. Drivers slide off of the road all the time, and a bit of recent price volatility sent many banks into insolvency.
Your example about the UK is noteworthy but I would argue that due to the dominance of US banks (and US regulations) in financial markets, UK banks are inclined to mirror US policies in order to remain competitive with US banks. Analogously, a Russian firm may adopt some US accounting practices if it wishes to attract investment from the US.
There are two factors: The first is the way that the bar is set by the regulation in the first place. T
he second is the grouping/incentive effect. If your competitor has too few reserves then you are at a disadvantage for not copying that behavior unless the economy crashes (such that your competitor goes out of business and you don't).