High & Low Finance: Grumbles Follow Plan to Raise Bank Capital

One result is that the American banks appear to have a competitive advantage. Being relatively well capitalized, they can afford to lend. That is less true in Europe.

Keep that fact in mind as the debate goes on about the new capital rules that United States regulators proposed this week for the largest American banks, the ones with more than $700 billion in assets. Some of those banks will need to have a lot more capital in a few years than they have now if the proposed rules are not watered down.

The banks were relatively restrained in their reactions this week, leaving it to trade groups to voice their complaints, which have a familiar ring to them.

“Ever-higher capital rules,” warned Robert S. Nichols, the president of the Financial Services Forum, which includes 19 large financial companies, “while a critically important element of safety and soundness, can become prohibitive and actually lead to reduced capability to lend to our nation’s families and businesses at a time when the economic recovery remains fragile.”

That there are bank capital rules at all stems from the issues a country faces when it provides deposit insurance. Depositors have no reason to care whether the bank is healthy, so a risky bank is not at a competitive disadvantage. The problem gets worse when those who buy bonds issued by banks conclude that their investments are effectively guaranteed by the government.

“Banks have creditors who are not worried about risks,” says Anat Admati, a Stanford finance professor and co-author of a book, “The Bankers’ New Clothes,” that calls for tougher capital rules. “If they were normal corporations, the creditors would not stand for it.”

It was never easy for regulators to determine how much capital was needed, but it became more difficult as financial innovations spread. That led to the 1988 adoption of model rules by a group of central banks and regulators that was based in Basel, Switzerland. That accord, later called Basel I, set up risk weightings for various types of assets, allowing for less capital for less risky assets. As the inadequacies of such a fixed system became clear, the regulators moved to one that allowed more fine-tuning, called Basel II. That allowed banks to use their own models — or credit ratings from Moody’s, Fitch and Standard Poor’s — to determine just how risky an asset was, and therefore how much capital was needed.

“Risk weighting is based on a very arcane, very complicated series of ratios and formulas that are immediately gamed and makes the system more fragile,” Thomas M. Hoenig, the vice chairman of the Federal Deposit Insurance Corporation, said this week after the F.D.I.C. voted to propose the new rules, along with other regulators. He said that the average risk weighting of bank assets fell, year after year, as the banks became better at coping with the rule.

Those risk-weighted assets form the basis of the capital figures banks cite. If a bank has 5 percent capital, it means capital equals 5 percent of the assets after risk adjustments. Until recently, government bonds from European countries were zero weighted, meaning that they did not count at all. Collateralized debt obligations — many of which turned out to be extremely risky — had only a 7 percent weighting, Mr. Hoenig said.

The result was that banks tended to load up on the highest-yielding assets with a given risk weighting. Because many mortgage securities had AAA ratings, that led banks as far away as Germany to lose a lot of money when the subprime mortgage market in the United States collapsed.

Under the latest, post-crisis rules — Basel III — there is supposed to be a leverage test as a supplemental measure. That measurement counts capital as a percentage of all assets — Treasury bills or junk bonds. The United States has long had such a test, though it was relatively lenient, but many other countries did not.

Floyd Norris comments on finance and the economy at nytimes.com/economix.

Article source: http://www.nytimes.com/2013/07/12/business/economy/big-banks-grumbling-about-planned-capital-rules.html?partner=rss&emc=rss