Inside Financial Services

Higher Capital Standards Are Not Enough

A loss of liquidity, not inadequate capital, is what often dooms banks

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Bank regulators continue to make a hash of their efforts to come up with uniform global capital standards. The latest evidence: earlier this month, U.S. regulators adopted a requirement that U.S. banks with over $700 billion in assets maintain a leverage ratio over 5% at the holding company, and over 6% at the bank, rather than a prior minimum of 3% at both.News flash: even those higher minimums won’t do much (if anything) to prevent another 2008-style financial meltdown.Before I explain why, a little history: The effort to come up with global capital standards began following the LDC lending crisis in the early 1980s, which threatened the soundness of some of the world’s largest banks. In addition, Japanese banks were using their lower capital ratios to underprice U.S. banks in domestic lending. The Basel Committee on Banking Supervision was formed to fix the problem by developing global standards that would effectively level the global playing field in bank regulation by raising the minimum capital requirements of the biggest banks.But what with different accounting principles in different countries, different risk characteristics in loan products, and different priorities among countries, it took years to hammer out the Basel I Capital Accord that eventually emerged. The basic underlying premise behind it was to require different levels of capital to be held for various asset classes, based on the committee’s estimate of risk. Thus were risk-based capital standards born.In hindsight, the idea was doomed. In its wisdom, for instance, the committee deemed that sovereign debt-even debt issued by countries like Greece!-needed zero capital to be held against it. Residential mortgage loans required just a 50% capital weighting. You know what eventually happened.Meanwhile, each country agreed that while the Basel standards would be the minimum, individual countries could require higher standards or additional standards. In the U.S., for instance, regulators set a minimum leverage ratio (simply capital to total assets), a measure that doesn’t take into account risk weighting, of 3%.Next came Basel II, in 2004. It essentially allowed the banks to risk-weight their assets based on their own internal models. This was another bad idea, which the world realized when the models blew up during the global financial meltdown. But the committee kept chugging away and came up with some fixes which became informally known as Basel II.5. Then more dramatic changes were put in place when Basel III was promulgated. It’s now being phased in worldwide. Basel III is a risk-based system more complicated than its predecessors. It generally requires banks to hold more capital than they’ve had to in the past. In addition, Basel III includes a minimum leverage ratio for all banks and requires the banks to maintain a minimum amount of liquidity.But as I, say, the rules are almost certainly inadequate to prevent another meltdown. We’ve already seen, first of all, that the risk-based approach doesn’t work. It’s obvious that neither man nor model can adequately assess a given asset’s risk under all circumstances before the fact. It doesn’t make sense to spend a lot of time trying. It does make sense to have a minimum leverage ratio–but it should be the same for banks of all sizes.More generally, the media, the Basel Committee, and U.S. regulators are all way too caught up in the notion that higher capital levels alone will save the big banks in the next financial crisis. They probably won’t. Even if the proposed new standards were in place in 2008, Lehman Brothers, Washington Mutual, and National City would have all failed anyway. Reason: their would-be creditors had zero confidence in the value of the banks’ assets, and so simply withheld short-term funding. It was a lack of liquidity that caused the banks’ demise rather than inadequate capital.To its credit, the Basel III committee did begin to address the liquidity issue (as did Janet Yellen in her comments last week). That’s good. In the meantime, these ever-higher capital standards regulators keep proposing will be costly to the banking industry but won’t forestall the next crisis.What do you think? Let me know!

7 Responses to “Higher Capital Standards Are Not Enough”

  1. SW Pilgrim

    Agree. Just look at the institutional buyers of Russian, Argentine and Venezuelan paper on the premise that there will be a tomorrow and plenty of time to off-load onto the “greater fool”.

  2. DSB

    Agreed. What seems to me to be missing in all of this is supervision. Without good supervision, regulation is almost worthless.

  3. Ben Dover

    @ DSB, couldn’t have stated it better. You have regulators who have been captured by the industry. Simple ratios and liquidity provisions could be helpful for monitoring if they are uniformly enforceable. To Tom’s point though, that was the craziest th

  4. oy

    And the solution is? Or do we just stand back, do nothing but carp about every proposed solution?

  5. Jonatha Finger

    Tom:

    I am not really sure I agree with your conclusion. I agree that Risk Weighted Assets is a flawed concept, especially when the banks are making their own assessment of the risk weights for certain assets. This creates incentives for RWA calculations based on ratings issued by “captive” rating agencies, which creates a race to the bottom in terms of standards.

    While not perfect, a leverage ratio is a more standardized calculation and level of capital that is harder for banks to manipulate. Therefore, I like a leverage ration calculation more than a risk weighted assets calculation. While one can argue about what the right level of leverage should be permitted, 5% / 6% is much better than 3% from a safety and soundness standpoint and creates a more realistic capital cushion in the event of a downturn or crisis.

    The next area of reform should be more required disclosures on banks to tell investor how they calculate Risk Weighted Assets and leverage ratios. Also, banks should be required to disclose levels of counterparty risk and consolidate any off balance sheet exposures. Greater disclosure = greater confidence. This will reduce funding crises and hopefully lower systemic risk.

  6. bank capitalist

    I know of some banks with 25% to 50% of assets held in UST securities or balances held with FRB. Increase in pure leverage ratios would now require these banks to hold more tier 1 capital against large levels of risk-free (in theory) assets. There is some use for capital to RWA concept.

  7. JRG

    Higher capital requirements will restrict growth and hopefully force banks out of high risk activities. Banking is not a growth business and needs to be brought back to its original role as a financial intermediary providing basic loan and depository services to consumers and businesses. At the same timeThere are too many banks in this country all trying to increase revenues in a declining market. Here in Columbus Ohio we have multiple in state and out of sate banks buying banks or opening LPOs. They cant find enough opportunity in their primary market so they come here. The local banks shake their heads as they cant grow in the market either and cant understand why this increased competition makes any sense. Regulators understand this and really want less banks.

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