Why banks need (way) more capital

December 14, 2011

The mantra that regulation is holding back the U.S. economic recovery is playing into Wall Street’s efforts to prevent significant reforms of the financial industry in the wake two major crises – one of which continues to rage in the heart of Europe. The sector’s staunch opposition to reform was captured in JP Morgan’s CEO Jamie Dimon’s claim that new bank rules are “anti-American.”

A new report from the Organization for Economic Cooperation and Development (OECD) suggests the opposition to substantially higher capital requirements is misguided. In particular, economist Patrick Slovik argues that a move away from the Basel accords’ “risk-weighted” approach to capital rules toward a hard-and-fast leverage ratio is the only way to prevent banks from finding creative ways to hide their true risk levels.

When the Basel accords first introduced the calculation of regulatory capital requirements based on risk-weighted assets, it was not expected that for systemically important banks the share of risk-weighted assets in total assets would consequently drop from 70% to 35%. Nor was it expected at the time that the financial system would transform high-risk subprime loans into seemingly low-risk securities on a scale that would spark a global financial crisis.  […] Tighter capital requirements based on risk-weighted assets aim to increase the loss-absorption capacity of the banking system, but also increase the incentives of banks to bypass the regulatory framework. New liquidity regulation, notwithstanding its good intentions, is another likely candidate to increase bank incentives to exploit regulation.

In addition, Slovik says market forces can only work properly if regulators debunk the perception that certain firms – like JP Morgan – are considered simply too big to be allowed to fail.

Increasing the capacity of markets to discipline banks will require addressing the too-big-to-fail problem, strengthening and rationalizing bank resolution regimes, and improving bank information disclosures.  […] The introduction of a leverage ratio based on non-risk-weighted total assets would help to align banks’ activities with their main economic functions and maximise capital-allocation efficiency. Although a common argument against a stringent leverage ratio is that it would increase bank lending cost and negatively affect the economy, this study has shown that the differences between the macroeconomic impact of risk-weighted and non-risk-weighted regulatory regimes are relatively low.

How are banks able to make the case that higher capital requirements would invariably harm economic growth? In part because of a common misperception about the basic nature of capital, argues Anat Admati, a finance professor at Stanford University’s Graduate School of Business. She says banks use deceptive language – parroted by the financial press – that suggests capital is money that has to be set aside and cannot be lent. This could not be further from the truth, Admati explains. Instead, higher capital requirements would simply force banks to fund themselves with more equity and less debt, thereby making institutions and the financial system much less risky. As she explained in an editorial:

It is critical first to distinguish capital and liquidity requirements. Capital requirements are not about what banks “hold.” They do not mandate that banks passively “set aside,” or “hold in reserve” funds, not putting them to productive uses. Banks’ investments are not constrained by capital requirements. Capital requirements refer only to how banks fund themselves. It is investors, not the banks, who hold the debt and equity (so-called “capital”) claims that banks issue. Liquidity requirements, by contrast, do constrain the types of assets banks hold, and they can be costly. Capital and liquidity requirements refer to different sides of the balance sheet.

In this context, Admati told Reuters in an email that dumping risk-weights as a premise for capital regulation, as proposed by the OECD paper, would be highly advisable.

Estimates of what would happen to GDP with increased capital requirements of any sort are flawed, the models used to estimate are always totally off.  But I am strongly in favor of abolishing the silly game of risk weights. And of course I am strongly in favor of banks going back to what banks do instead of obsessing about these unproductive games to get a little more hidden leverage.

Along those lines, Slovik’s research elucidates just how perverse the incentives created by risk-weighted capital rules proved to be: it stopped them from lending, not because they were forced to set money aside, but rather because they were able to make greater profits in other areas such as trading.

A core function of banks is to actively search for and evaluate lending opportunities and advance loans to credit-worthy enterprises and households. In the past such activities accounted for the major share of large banks’ assets. However, this share has declined substantially over time.

Slovik analyzed historical data on loans as a percentage of total assets for selected large banks in the United States, the United Kingdom, Germany, France, and Switzerland. This is what he found:

The loan portfolio represented around 75% of total assets of these banks in the early 1990s. Thereafter, the ratio of loans to total assets gradually declined to a low of around 30% in the immediate pre-crisis period. One of the main reasons why non-loan-related activities have become so important for banks is the relatively high regulatory risk-weights on loans relative to other types of assets, which puts them at a comparative disadvantage in the profit-seeking strategies of banks. In effect, capital regulation based on risk-weights creates incentives for banks to focus on non-lending activities.

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