Bank safety is in the eye of the beholder

November 29, 2012

Too-big-to-fail banks are bigger than ever before. But top regulators tell us not to worry. They say the problem has been diminished by financial reforms that give the authorities enhanced powers to wind down large financial institutions. Moreover, supervisors say, the new rules discourage firms from getting too large in the first place by forcing them to raise more equity than they had prior to the financial meltdown of 2007-2008.

New York Fed President and former Goldman Sachs partner William Dudley said in a recent speech:

There has already been considerable progress in forcing firms to bolster their capital and liquidity resources. On the capital side, consistent with the Dodd-Frank Act, Basel III significantly raises the quantity and quality of capital required of internationally active bank holding companies. This ensures that the firm’s shareholders will bear all the firm’s losses across a much wider range of scenarios than before. This should strengthen market discipline. Meanwhile, to the extent that some of the specific activities that generate significant externalities are now subject to higher capital charges, this should cause banks to alter their business activities in ways that reduce both the likelihood and social cost of their failure.

Moreover, the new Basel regime explicitly adjusts capital requirements upward based on size, complexity, interconnectedness, global exposure and substitutability – attributes that are proxies for the negative externalities generated by failure. If a bank is deemed a global systemic financial institution or G-SIFI, then it will have to hold a greater amount of capital relative to its risk-weighted assets compared to a less systemic institution.

Dudley admits Basel III itself may not be enough:
One could make a good case that the capital surcharge for systemically important firms should be higher than that contemplated by the Basel Committee.

But for proponents of much higher capital requirements that would force banks to rely less heavily on leverage, there is no question. They argue Basel III changes are not nearly sufficient to allow supervisors – and therefore taxpayers, who are still on the hook for these supersized financial firms – to sleep soundly.

Anat Admati, professor of finance at Stanford University’s Graduate School of Business and author of the forthcoming book “The Bankers’ New Clothes,” says the latest round of international Basel III reforms, which European bank lobbies are still fighting hard to delay, are little more than window dressing.

Basel III is entirely insufficient and flawed. From the perspective of the public interest in having a stable and healthy financial system, there is no justification for not going significantly beyond Basel III in terms of reducing leverage. The 3% equity to total assets is outrageously low, and the system of risk weights used in Basel is highly problematic.

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