Basel III Endgame: Capital Rules for Technocrats
I have read the bank regulators’ most recent capital proposal, sometimes referred to as the Basel Endgame. Those interested in engaging in a mind-numbing exercise can read the 1000-page proposal at their leisure and then file it with the thousands of pages of Basel rules already pulling the banking industry under water. Its purpose is to tweak the Basel risk-weighted capital standards for the largest systemically important national and regional banks to better allow for market (trading) and operational risks. The proposed rule is full of new equations and risk concepts unrealistically intended to capture the always changing risks that bankers deal with daily. The proposal follows the banking crisis that occurred this past March, but only a small portion of it relates to that event.
I have long criticized the use of the Basel risk-weighted capital standards. How many times must something fail before the regulators abandon it? The development of the Basel standards costs the banking industry and regulators billions of dollars for development and implementation, and yet, financial crises remain a mainstay of the industry. For example, although the risk-weighted capital standard gained prominence as the best measure of balance sheet strength during the decade preceding the 2008 financial crisis, it overstated industry resilience to that financial shock. In contrast, the industry’s weakness was more apparent when the leverage ratio - capital funding each dollar of bank assets – was calculated and shown to be only 5 percent. As the economic crisis of 2008 erupted, bank industry losses quickly absorbed much of that capital, eventually requiring a government bailout.
Currently, the Basel risk-weighted capital measure indicates that the largest globally systemic banks (GSIBs) have capital funds equal to 14 percent of their risk-weighted asset. But risk-weighted assets account for less than half their total assets at risk. The GSIB’s supplemental leverage ratio - capital funds as a percent of total assets and risk exposure – is under 6 percent, not much higher than it was in 2008. Also, risk weighted capital for regional banks greater than $100 billion averages just over 11 percent while their supplemental leverage ratio averages 7.4 percent, also not much higher than its level in 2008.
Judging the industry’s financial strength through the prism of the leverage ratio shows an industry more vulnerable to economic shock than that shown through the risk-weighted ratio. It shows an industry that would benefit from higher levels of capital supporting the balance sheet. Even so, regulators insists that the industry is well capitalized and sound. If so, however, it is odd that during the latest banking crisis, the FDIC and Fed again had to bailout the industry with deposit guarantees, and the FDIC had to absorb billions of dollars of industry losses. Simply put, ownership capital was insufficient to absorb anywhere near the losses incurred and, therefore, was insufficient to hold the public’s confidence.
It should be no surprise that when the industry begins to experience problems, investors, the public and the regulators immediately turned to the leverage ratio as the best means to judge the solvency and resilience of the industry. Losses can come from any type of asset, including those that the regulator judges to be risk free. The losses at Silicon Valley Bank came from its government and government guaranteed bonds against which little ownership capital was required. Thus, as this instance illustrates, the risk-weighted capital standard is often a misleading indicator of financial strength and can be counterproductive when judging a bank’s financial resilience.
Unfortunately, after spending billions of dollars developing these complex rules, and billions more implementing them, it is difficult for the technocrats to abandon their investment of time and money for a simpler and more understandable capital program. Perhaps it’s time to admit that the risk-weighted capital standard simply doesn’t work.
The leverage ratio will not end failures. However, it will enhance market discipline as it reveals to the public, bank managers and regulators how much ownership has at stake in the success of a bank, and just how much loss a bank can withstand before it becomes insolvent. The leverage ratio is far simpler to compute, and a far better indicator of balance sheet strength.