Do banks really need more capital?

Sep 28, 2011 20:04 UTC

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.


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

Jamie Dimon is right: Who Needs Basel III?

Sep 14, 2011 15:12 UTC

It’s beyond ironic — closer to moronic, really — that Jamie Dimon would give an interview to London’s very own Financial Times, complaining that international bank-regulation standards are “anti-American,” on the very day that the Vickers ReportRobert Peston calls it “the most radical reform of British banks in a generation, and possibly ever” — is released.

–Felix Salmon
Dimon vs Vickers

I have to disagree with Felix Salmon and agree with JP Morgan Chairman & CEO Jaime Dimon that Basel III is an anti-American nightmare and needs to go. There are many reasons why Basel III is irrelevant to the management and regulation of banks in the United States. In general, Basel is a poor risk management scheme for measuring bank capital adequacy.

First and foremost, the Basel III risk weighting standards are nonsense, with securitized and government guaranteed exposures given superior treatment (and lower risk weights) than comparable loans. Under Basel III as with the previous iterations of the Basel framework, lending is seen as bad, while complex structured securities, illiquid fiat currencies and OTC derivatives are still somehow seen as superior risks – even with the experience of the past decade of subprime residential mortgage backed securities (RMBS).

This entire framework is incredible, especially if you look at the use of quantitative models and statistics to generate default probabilities at the portfolio level to feed into the Basel III capital models. Basel III is a celebration of efficient market theory and economist guesswork, something that most reputable analysts and researchers have long ago rejected as pure garbage when it comes to risk analytics. Yet the Basel regulators continue to embrace this discredited approach. Why? Because, very frankly, the macro economists who dominate the Euro-American bank supervisory community have nothing else available to replace it.

Second and more important, the Basel III guidelines are rarely relevant to the managers of American banks. Because US banks still live with the more severe and arbitrary discipline of a leverage ratio, basically assets vs. capital measured without the benefit of ersatz risk weightings, managers of American depositories rarely run out of risk weighted capital as per Basel III, but leverage is a constant constraint. Whether a bank has too little or too much risk weighted capital is largely relevant only to regulators and lawyers.

Because agencies such as the FDIC under former Chairman Sheila Bair insisted on the retention of the leverage ratio for US banks, lenders such as JP Morgan have twice the capital to total assets of their EU counterparts, part of the reason for the lack of confidence in EU banks. Say what we may about Bank of America and other troubled lenders, but US banks still have substantially more capital than do banks around the world and especially in the Eurozone. To Felix’s point about Basel III being obviously good for American interests, I strongly disagree. Our rejection of the fantasy world of Basel III risk-weights saved American banks from looking like the insolvent shells of the EU today. From a practical as well as nationalist American perspective, who needs Basel III?

Third and more importantly, Basel III is extremely bad for the US housing sector at a very bad time. Reflecting the Euro bias of the Basel III apparatchiks at the Bank for International Settlements, the new framework demonizes mortgage assets, especially servicing rights. Nobody at the Fed, OCC or FDIC had the wit to object to this proposal, but this alone is reason enough for the US Senate to demand that President Obama withdraw from Basel III. Unless this ridiculous rule is changed, many US banks will essentially be forced to exit the residential loan servicing and warehouse lending businesses.

At a time when the US needs to be creating new capacity to support credit and leverage, adopting the Basel III rule is a bad idea. While some observers like Felix Salmon pay lip service to the illusion of international coordination of bank supervision, a more realistic view is that national treatment and rules remain the practical reality. When you look at the ridiculous pretense of EU banks referring to “risk weighted” capital ratios instead of simple leverage in their public disclosure, the bankruptcy of the Basel III process is visible for all to see.

Making US banks operate under rules that are acceptable to regulators in the EU, where most of the banks are insolvent or nationalized, seems like a particularly bad idea at present. Since the adoption of the first Basel accord three decades ago, the asset quality and solvency of EU banks have steadily deteriorated and American institutions have drifted into progressively riskier and opaque derivatives. Why should we follow this failed example for another moment longer? Dimon is right: America should withdraw from Basel III and embrace traditional American standards like the leverage ratio as the road to sanity and solvency in terms of prudential regulation for banks.



No, America should not withdraw from Basel III for many reasons.

There is nothing anti-American in Basel iii. Anti-American is the effort to take excessive risks and escape regulation. Anti-American is the strategy to speculate and when you win you keep the money, when you fail you are saved with other people’s money. Anti-American is also the effort to appear as a patriot when you try to hide your real agenda.

Basel iii is a minimum standard, not an accurate standard. It is a basis, and banks have to do more than the minimum (important Pillar 2 principle). If you want to do more than the basic Basel iii rules that you find wrong, you are following the new Basel iii rules.

Is Basel iii an excellent framework? No, it is not. But it is the best we have now. We can make it better. This is the way we build international standards.

George Lekatis

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Basel III in the age of sovereign default

Aug 1, 2011 19:06 UTC

Last week I described what the prospective default by the US does to the bond markets in terms of spread relationships with supposed “risk free” rate of return represented by government bonds in a research note, “Black Friday and the end of risk free returns”:

The benchmark treasury curve has been been loosed from the bounds of earth and is now a relative benchmark, where “superior” corporate credits can and will be priced through Treasury and agency yields on a regular basis. If this sounds a little too much like the world of quantum physics and Steven Hawking, all we can do is borrow a line from Joan McCullough at East Short Partners: ‘Get used to it.’

Another friend and mentor, Alex Pollock of the American Enterprise Institute, noted in a letter of the Financial Times that there is no such thing as a risk free rate of return. To that point, 100 years ago the United States had no international credit rating — or credit — and was forced to operate through the great New York banks when it came to international payments. How quickly we forget.

By the end of WWII, the US discarded the proposal of J.M. Keynes for a competitive, multilateral currency system and instead took a page from the Roman Empire and equated the dollar with gold. This symbolically and functionally associated the dollar with risk-free assets, at least for a few decades, but now the size of the US federal debt and commitments makes this implication indefensible as a practical matter.

From Nixon’s closure of the gold window in 1972 through to the present day, the US has been on a steady financial course toward default — even if investors do not want to believe it. Now we are “thinking about the unthinkable,” to borrow the title of Herman Kahn’s seminal 1968 book about the reality of nuclear war, only now with respect to financial default in the US as well as in the EU.

For bankers attempting to model forward loss rates and capital requirements, as is now required by federal regulators, how to model sovereign risk raises some thorny issues. Since it is now possible for a nation like the US to ponder default for purely political reasons instead of because of an incapacity to pay, should banks still carry such risk exposures at zero weighting for Basel III capital purposes?

At present, the Basel III framework does not require any capital or reserves for sovereign debt of a certain credit rating. “Lending to AA-rated sovereigns still carries a risk-weight of zero,” the Economist noted last September in a prescient article. So even if the US was downgraded as a result of the childish manner in which fiscal issues are being mismanaged in Washington, banks would still not need to put any capital behind Treasury bonds.

But the fact is, that downgraded or not, investors have looked at the US as a weakening credit for many years. The spread to purchase five-year protection in the market for credit default swaps is now 68 basis points or 0.68% per year. If you compare the ratings scale used by Moody’s and S&P to describe probability of default, a 68bp spread in CDS is roughly equivalent to a “BBB” bond rating. It seems that in the minds of foreign investors, at least, the US is already a lower tier investment grade credit — as much for the ability to pay as for the willingness to enforce reasonable standards of national governance.

At the end of the day, investors looking out over the five year horizon of a CDS contract must ask whether they think the US fiscal situation and the purchasing power of the greenback are likely to improve in half a decade’s time. The answer regrettably is no, if the latest “budget deal” from Washington is any measure. It might be better for Congress to miss the debt ceiling vote, at the end of the day, if it makes the subsequent discussions more purposeful and serious.

For bankers and regulators seeking to enhance the safety and soundness of financial institutions, the new revelations about the possibility of default in the US and EU raise the possibility that top-quality corporations will be trading at tighter spreads and superior credit ratings than sovereign states. Perhaps far from being a surprise, the relatively better management and governance of the best global enterprises may augur the demise of the 19th century nation state. Should Basel III be adjusted to recognize the reality in the marketplace? Heaven forbid.



The key to the future of finance is now emerging

Sep 15, 2010 18:19 UTC

This week I lovingly disparaged those members of the media who spent much time covering the new and improved bank regulatory scheme known as “Basel III.” As someone who was quizzed by my father about the original 1988 Basel accord, I don’t give a toasted sausage about Basel III and said so recently:

Basel III is entirely irrelevant to the economic situation and even to the banks. Through things like minimum capital levels, the Basel II rules provided the illusion of intelligent design in the regulation of banking and finance. In fact, Basel II made the subprime crisis possible and the subsequent bailout inevitable [by enabling off-balance sheet finance and OTC derivatives].

Part of the reason for my undisguised contempt for the Basel III process comes from caution regarding the benefits of regulating markets. In the 1930s, the U.S. government took responsibility for the soundness of banks and markets.  Since then we’ve had nothing but an accumulation of public sector debt and growing market volatility, begging the question as to whether the Treasury’s legal monopoly on regulating a market filled with fiat paper dollars is really a public good.

But a large portion of my criticism for Basel III and the entire Basel framework is even more basic, namely the notion that any form of a priori regulation, public or private, can prevent people from doing stupid things. Neither the failure of Lehman Brothers nor Bear Stearns were caused by a lack of capital. “When a bank goes bad, it doesn’t make much difference how much capital it has,” former Fed Chairman Paul Volcker said recently.

To me, the even more offensive thing about Basel II/III is the financial and economic assumptions which underlie the framework. This week in The Institutional Risk Analyst, we republished the written Testimony of David Colander as submitted to the Congress of the United States, House Science and Technology Committee on July 20, 2010. His views on what is right and wrong with economists and the world of economic research are very much at the heart of the problems with Basel III, at least as sold by regulators to their respective voters in the G-20 nations.

The key premise of Basel III is that the use of minimum capital guidelines and other strictures will somehow enable regulators to prevent a crises before it occurs. The only trouble is that regulators have no objective measures for compliance with Basel II/III, much less predicting market breaks. There is also the larger issue of the conflict between the Fed’s monetary policy role and its job as regulator.

Fed Chairman Ben Bernanke told Congress recently that the Fed and other regulators must rely on the disparate internal systems of the banks to monitor compliance with regulations. But this assumes that bank managers themselves understand the risks they face. Do you think JPMorgan CEO Jamie Dimon knew last week that his bank had a serious problem with its website? Risk is no more predictable than life and no more amenable to statistical forecasts than the weather.

As in past decades and crises right through to 2008, the regulators will be the last to know about a problem. The fact that the Fed and other agencies have no objective means of measuring compliance with Basel III and other regulatory norms is but your first hint of trouble. Add to that basic problem the use of suspect methodologies to measure risk and thus prescribe minimum capital levels. This is the next indication of serious issues with the regulatory status quo which is now reaffirmed in Basel III.  Then add to that the lack of a unified set of accounting rules and the de facto regime of “national treatment” that prevails within the G-20 nations, and it seems reasonable to ask whether Basel III is really worth all of the trouble and bother.

What is more important than Basel III for customers and creditors of and investors in banks? The accounting rules changes on off-balance sheet (OBS) vehicles and the fair-value crusade being led by the Financial Accounting Standards Board are top of the list for our clients.

The EU and SEC/FDIC rules processes on securitization are #2 on the important list. While everyone focuses on Basel III, the key to the future of finance is emerging now with the implementation by the EU of something called “Article 122a” regarding asset backed securities (ABS).

Article 122a is an amendment to the European Capital Requirements Directive. Specifically, it requires European credit institutions that invest in structured finance securities to know what they own. It lays out explicit penalties if a European credit institution does not obtain sufficient data regarding an ABS to satisfy regulators that the buyer fully understands the security.

Would that American regulators dared to propose anything remotely like Article 122a to bring order to the U.S. market for structured notes and derivative securities. Indeed, the divergence in goals and objectives between the EU and the U.S. over bank regulation could grow after the November election, when the Republicans are expected to win big. My prediction is that if the Republicans prevail at the polls, the U.S. may go its own way on Basel III. Stay tuned.