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.