The Role of Capital in Financial Institutions

This paper examines the role of capital in financial institutions. As the introductory article to a conference on the role of capital management in banking and insurance, it describes the authors' views of why capital is important, how market-generated capital requirements' differ from regulatory requirements and the form that regulatory requirements should take. It also examines the historical trends in bank capital, problems in measuring capital and some possible unintended consequences of capital requirements. According to the authors, the point of departure for all modern research on capital structure is the Modigliani-Miller (M&M, 1958) proposition that in a frictionless world of full information and complete markets, a firm s capital structure cannot affect its value. The authors suggest however, that financial institutions lack any plausible rationale in the frictionless world of M&M. Most of the past research on financial institutions has begun with a set of assumed imperfections, such as taxes, costs of financial distress, transactions costs, asymmetric information and regulation. Miller argues (1995) that these imperfections may not be important enough to overturn the M&M Proposition. Most of the other papers presented at this conference on capital take the view that the deviations from M&M s frictionless world are important, so that financial institutions may be able to enhance their market values by taking on an optimal amount of leverage. The authors highlight these positions in this article. The authors next examine why markets require' financial institutions to hold capital. They define this capital requirement' as the capital ratio that maximizes the value of the bank in the absence of regulatory capital requirements and all the regulatory mechanisms that are used to enforce them, but in the presence of the rest of the regulatory structure that protects the safety and soundness of banks. While the requirement differs for each bank, it is the ratio toward which each bank would tend to move in the long run in the absence of regulatory capital requirements. The authors then introduce imperfections into the frictionless world of M&M taxes and the costs of financial distress, transactions costs and asymmetric information problems and the regulatory safety net. The authors analysis suggests that departures from the frictionless M&M world may help explain market capital requirements for banks. Tax considerations tend to reduce market capital requirements , the expected costs of financial distress tend to raise these requirements , and transactions costs and asymmetric information problems may either increase or reduce the capital held in equilibrium. The federal safety net shields bank creditors from the full consequences of bank risk taking and thus tends to reduce market capital requirements . The paper then summarizes the historical evolution of bank capital ratios in the United States and the reasons regulators require financial institutions to hold capital. They suggest that regulatory capital requirements are blunt standards that respond only minimally to perceived differences in risk rather than the continuous prices and quantity limits set by uninsured creditors in response to changing perceptions of the risk of individual banks. The authors suggest an ideal system for setting capital standards but agree that it would be prohibitively expensive, if not impossible. Regulators lack precise estimates of social costs and benefits to tailor a capital requirement for each bank, and they cannot easily revise the requirements continuously as conditions change. The authors continue with suggestions for measuring regulatory capital more effectively. They suggest that a simple risk-based capital ratio is a relatively blunt tool for controlling bank risk-taking. The capital in the numerator may not always control bank moral hazard incentive; it is difficult to measure, and its measured value may be subject to manipulation by gains trading . The risk exposure in the denominator is also difficult to measure, corresponds only weakly to actual risk and may be subject to significant manipulation. These imprecisions worsen the social tradeoff between the externalities from bank failures and the quantity of bank intermediation. To keep bank risk to a tolerable level, capital standards must be higher on average than they otherwise would be if the capital ratios could be set more precisely, raising bank costs and reducing the amount of intermediation in the economy in the long run. Since actual capital standards are, at best, an approximation to the ideal, the authors argue that it should not be surprising that they may have had some unintended effects. They examine two unintended effects on bank portfolio risk or credit allocative inefficiencies. These two are the explosive growth of securitization and the so-called credit crunch by U.S. banks in the early 1990s. The authors show that capital requirements may give incentives for some banks to increase their risks of failure. Inaccuracies in setting capital requirements distort relative prices and may create allocative inefficiencies that divert financial resources from their most productive uses. During the 1980s, capital requirements may have created artificial incentives for banks to take off-balance sheet risk, and changes in capital requirements in the 1990s may have contributed to a credit crunch.

Exchange between deep donors in semiconductors: a quantum defect approach

Exchange interactions among defects in semiconductors are commonly treated within effective-mass theory using a scaled hydrogenic wave-function. However such a wave-function is only applicable to shallow impurities; here we present a simple but robust generalization to treat deep donors, in which we treat the long-range part of the wavefunction using the well established quantum defect theory, and include a model central-cell correction to fix the bound-state eigenvalue at the experimentally observed value. This allows us to compute the effect of binding energy on exchange interactions as a function of donor distance; this is a significant quantity given recent proposals to carry out quantum information processing using deep donors. As expected, exchange interactions are suppressed (or increased), compared to the hydrogenic case, by the greater localization (or delocalization) of the wavefunctions of deep donors (or `super-shallow' donors with binding energy less then the hydrogenic value). The calculated results are compared with a simple scaling of the Heitler-London hydrogenic exchange; the scaled hydrogenic results give the correct order of magnitude but fail to reproduce quantitatively our calculations. We calculate the donor exchange in silicon including inter-valley interference terms for donor pairs along the $\{100\}$ direction, and also show the influence of the donor type on the distribution of nearest-neighbour exchange constants at different concentrations. Our methods can be used to compute the exchange interactions between two donor electrons with arbitrary binding energy.Comment: 11 pages, 10 figures, RevTeX

Low temperature shape relaxation of 2-d islands by edge diffusion

We present a precise microscopic description of the limiting step for low temperature shape relaxation of two dimensional islands in which activated diffusion of particles along the boundary is the only mechanism of transport allowed. In particular, we are able to explain why the system is driven irreversibly towards equilibrium. Based on this description, we present a scheme for calculating the duration of the limiting step at each stage of the relaxation process. Finally, we calculate numerically the total relaxation time as predicted by our results and compare it with simulations of the relaxation process.Comment: 11 pages, 5 figures, to appear in Phys. Rev.

On the Geometry of Surface Stress

We present a fully general derivation of the Laplace--Young formula and discuss the interplay between the intrinsic surface geometry and the extrinsic one ensuing from the immersion of the surface in the ordinary euclidean three-dimensional space. We prove that the (reversible) work done in a general surface deformation can be expressed in terms of the surface stress tensor and the variation of the intrinsic surface metric

Anisotropic diffusion in continuum relaxation of stepped crystal surfaces

We study the continuum limit in 2+1 dimensions of nanoscale anisotropic diffusion processes on crystal surfaces relaxing to become flat below roughening. Our main result is a continuum law for the surface flux in terms of a new continuum-scale tensor mobility. The starting point is the Burton, Cabrera and Frank (BCF) theory, which offers a discrete scheme for atomic steps whose motion drives surface evolution. Our derivation is based on the separation of local space variables into fast and slow. The model includes: (i) anisotropic diffusion of adsorbed atoms (adatoms) on terraces separating steps; (ii) diffusion of atoms along step edges; and (iii) attachment-detachment of atoms at step edges. We derive a parabolic fourth-order, fully nonlinear partial differential equation (PDE) for the continuum surface height profile. An ingredient of this PDE is the surface mobility for the adatom flux, which is a nontrivial extension of the tensor mobility for isotropic terrace diffusion derived previously by Margetis and Kohn. Approximate, separable solutions of the PDE are discussed.Comment: 14 pages, 1 figur

Extremely Correlated Quantum Liquids

We formulate the theory of an extremely correlated electron liquid, generalizing the standard Fermi liquid. This quantum liquid has specific signatures in various physical properties, such as the Fermi surface volume and the narrowing of electronic bands by spin and density correlation functions. We use Schwinger's source field idea to generate equations for the Greens function for the Hubbard operators. A local (matrix) scale transformation in the time domain to a quasiparticle Greens function, is found to be optimal. This transformation allows us to generate vertex functions that are guaranteed to reduce to the bare values for high frequencies, i.e. are ``asymptotically free''. The quasiparticles are fractionally charged objects, and we find an exact Schwinger Dyson equation for their Greens function. We find a hierarchy of equations for the vertex functions, and further we obtain Ward identities so that systematic approximations are feasible. An expansion in terms of the density of holes measured from the Mott Hubbard insulating state follows from the nature of the theory. A systematic presentation of the formalism is followed by some preliminary explicit calculations.Comment: 40 pages, typos remove

Self Consistent Expansion for the Molecular Beam Epitaxy Equation

Motivated by a controversy over the correct results derived from the dynamic renormalization group (DRG) analysis of the non linear molecular beam epitaxy (MBE) equation, a self-consistent expansion (SCE) for the non linear MBE theory is considered. The scaling exponents are obtained for spatially correlated noise of the general form $D({\vec r - \vec r',t - t'}) = 2D_0 | {\vec r - \vec r'} |^{2\rho - d} \delta ({t - t'})$. I find a lower critical dimension $d_c (\rho) = 4 + 2\rho$, above, which the linear MBE solution appears. Below the lower critical dimension a r-dependent strong-coupling solution is found. These results help to resolve the controversy over the correct exponents that describe non linear MBE, using a reliable method that proved itself in the past by predicting reasonable results for the Kardar-Parisi-Zhang (KPZ) system, where DRG failed to do so.Comment: 16 page

Perceptions on the role of evidence: an English alcohol policy case study

This paper explores the competing influences which inform public health policy and describes the role that research evidence plays within the policy-making process. In particular it draws on a recent English alcohol policy case study to assess the role of evidence in informing policy and practice. Semi-structured interviews with key national, regional and local policy informants were transcribed and analysed thematically. A strong theme identified was that of the role of evidence. Findings are discussed in the context of competing views on what constitutes appropriate evidence for policy-making

Soft methods, hard targets: regional alcohol managers as a policy network

Regional Alcohol Managers (RAMs) was employed in the nine English health regions over 2008–2011. Their mission was to impact on the ‘hard target’ of Alcohol-Related Hospital Admissions (AHRAs) through the ‘soft methods’ of persuasion and influence: working with local partners on evidence-based interventions. Drawing on a qualitative evaluation, this article shows how a central government policy imperative (ARHAs) led to ‘government at a distance’ responses, including the introduction of RAMs. The processes involved in shaping and delivering this function bore the hallmarks of a complex, interactive policy network model, involving individuals whose bearings and roles were flexible and sometimes ambiguous. While there were overlaps and blurring of boundaries, there were three levels of policy network: central government, regional and local. As the ‘network in the middle’, the RAMs were pulled in both directions by conflicting agendas but were also able to have an impact on central and local policy