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The superstructure of financial reform may be stalled in Congress, but at least regulators are forcing banks to raise capital. Since the nadir of the financial crisis in the fourth quarter of 2008, the Big Four have more than doubled their common equity, raising another $55 billion just in the fourth quarter.
The question is whether they’ve raised enough. With capital only a bit above early ’08 levels, especially among regional banks, the answer is most likely no.
Stepping back for a minute, it’s helpful to remember why capital is so crucial. The most important reason is that it provides a buffer to absorb losses from the asset side of the balance sheet. As assets are written down, a too-thin equity capital cushion leads to a run among creditors who race to get out before taking a loss. Bank runs — whether the run-of-the-mill type among depositors or the high finance equivalent among short-term creditors — can quickly bring a financial system to its knees.
Luckily, regulators appear to be laser-focused on capital. Documents published in December by the Basel Committee — an international collection of bank regulators — would redefine capital in a number of productive ways.
More stringent capital requirements are also a back door way to accomplish other regulatory goals. For instance, the “size” component of the recently proposed “Volcker Rules” is designed to limit reliance on non-deposit liabilities. The more capital banks are required to hold, the smaller these liabilities.
In a recent note to clients, Jason Goldberg of Barclays Capital said the Basel proposals will…
…present onerous requirements on banks, especially the capital and leverage ratio calculations. If this ratio were to be implemented, we believe that the impact would be substantial on those banks with large derivative books, as well as those who participate in the short-term funding markets and those banks who maintain large off balance sheet commitments…
To anyone other than a banker or bank shareholder, that all sounds fantastic. But celebrations would be premature. Some proposals could get watered down or thrown out, for one.
And while the definition of capital would change for the better, Basel has yet to outline what levels of capital will be required. (It may leave this to national regulators.) If required levels are set too low, banks will continue to be vulnerable to runs.
True, the asset side of the balance sheet doesn’t look as vulnerable as it did a year ago, what with many assets written down already. But banks still seem to be sitting on big losses.
Take, for instance, second-lien mortgages. The Big Four U.S. commercial banks carried $442 billion worth as of Q3 ’09. That’s about equal to their total tangible common equity.
Second-liens like home equity loans are subordinate to first mortgages, theoretically worthless if the value of the home falls below the balance on the first mortgage.* With a huge chunk of U.S. real estate under water, the embedded losses here are huge.
So it’s good news that banks are raising capital, and that regulators are redefining it in a way that will make it more robust. But it’s too early to claim victory. Much more capital is needed before the financial system can stand on its own.