Do banks really need more capital?

September 28, 2011

Global regulators are united in the belief that banks need more capital. The crisis of the past five years or so, regulators testify, requires more capital. Former FDIC Chairman Sheila Bair, upon hearing my heretical ideas on the US rejecting Basel III entirely, asked me whether I supported her and US regulators in seeking more capital in general.

My answer was no and here’s why: deflation, not capital, is the most urgent problem.

I’ve supported the views of JP Morgan CEO Jamie Dimon that Basel III is un-American and should be abandoned by the US. But both of us may be wrong on the provenance of the Basel framework. My friend Stephan Richter, publisher of The Globalist, believes that the US side actually created this entirely anti-American, authoritarian celebration of macroeconomc babble. We shall hear more on this when he completes his research on the fathers of Basel III. Comments are welcome.

But I think we can all agree that the statist, anti-democratic construction of Basel III is out of step with traditional ideas of American democracy and free enterprise. The world of Basel III is all about top down management of the economy, the sort of socialist claptrap that was introduced into the US political mainstream after the two world wars. Banks are, in fact, run like most other businesses, from the branch level up to the head office, but the deterministic world of Basel III is entirely European in outlook.

Whether you are GE Capital or Cullen/Frost Bankers, business opportunity and risk start from particular credit events. Regulations and capital requirements are all very fine when approached in a reasonable and transparent way. Yet the speculative, portfolio-level constructs of Basel III and the ridiculous mathematics behind it should be rejected when it comes to determining capital adequacy for any financial institution. But there is a larger reason why we need to drive a couple of wooden stakes in the chest of Basel III during this Halloween season.

Americans need to reject new era concepts such as market efficiency and fair value accounting, two of the key pillars of the Basel III world that encouraged the growth of opaque OTC markets in mortgage securities and derivatives. In good times, Basel III was an enabler for bad banking practices and excessive leverage. Now we are seeing the very same global bureaucrats who fomented the financial bubble rush around setting new, incomprehensible rules that we call “Basel III.”

The use of more direct measures of risk, such as leverage ratios and real-world estimates of specific obligor default probability, offer a far better route than Basel III and has in fact served the US banking system well for decades. But to the specific point raised in the discussion of Basel III, the fact is that most US banks do not need more capital. What banks need is less regulation of making good loans and clear, unambiguous rules for selling and servicing loans in the secondary markets.

If you look at the data from the FDIC as well as economic capital models created by my firm and others, the picture in the US banking industry is actually the under-employment of capital and a net run off of assets. Jamie Dimon is right to go on the attack when it comes to oppressive regulation and acts of collective delusion like Basel III because they hurt growth and job creation.

The real question which needs to be asked is why other members of the banking industry and the broader business community are not standing with Dimon and complaining about the monumental display of incompetence we see in Washington today in the form of Dodd-Frank. The reaction of the global political class to mounting debt deflation is to increase regulation and raise bank capital levels, thus worsening deflation and unemployment. Regulators encourage banks to cut counter-party credit lines with other banks to “limit risk.” This is precisely the type of bizarre thinking that drives the debt deflation affecting all of the industrialized nations.

Members of the chattering classes in the media should not be so quick to dismiss the warnings of Dimon and other less well-known bank executives when it comes to the negative effect of Basel III and Dodd-Frank on capital formation and job creation. Maybe in the teeth of this winter, when economic hardship and unemployment are the front-page news each and every day, the advocates of endless regulation and meaningless exercises such as Basel III and Dodd-Frank will reconsider their collective folly.

One comment

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Surely the (only) purpose of Basel is to protect deposits in the case of bank failure. Everything else is a superfluous add on. Basel’s failure (if one accepts the premise that capital is the right safeguard) is every time it is shown to be not fit for purpose, the Committee tack something else on so we now have a cumbersome and complex regulation that probably will still fail.

Go back to first principles:

1. Do we need to protect depositors? Why?

2. If yes, then what is the best way to do this?

3. Accept that what has been done is failing and build a new accord (the word itself means concurrence of opinion – which we don’t have) which limits itself to the agreed principles of purpose and does not stray into other areas.

Posted by DMillar | Report as abusive