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When Is Capital Really Adequate?

By: Bill Poquette

Federal regulators are agreed that the biggest banks need more capital and this concept is embedded in the Dodd Frank-Act and proposed Basel III rules. These rules are still being tweaked, however, and arguments are being raised for more simplicity and transparency in how capital is measured.
In an economic letter from the Federal Reserve Bank of Dallas, author Michael A. Seamans frames the issue as follows: “Over time, regulatory capital ratios have evolved along with the shifting landscape of banking, becoming more complex in an effort to capture the risks of an increasingly complicated financial world,” he wrote. “Financial crisis experience suggests that it is unclear whether ratio complexity enhances the ability to identify failure and is better than a simpler ratio. But a simpler ratio offers the benefits of greater transparency and accountability.” Seamans is a financial industry analyst at the Dallas Fed.

FDIC Vice Chairman Thomas M. Hoenig was quite blunt in his assessment of Basel III capital in a recent speech, labeling it “a well-intended illusion.”

Addressing the International Association of Deposit Insurers in, yes, Basel, Switzerland, he noted that in the Basel capital standards, world supervisory authorities rely principally on a Tier 1 capital ratio to judge the adequacy of bank capital and balance sheet strength. “For the largest of these firms, each dollar of risk-weighted assets is funded with 12 to 15 cents in equity capital, projecting the illusion that these firms are well capitalized,” Hoenig said.

“We know from years of experience using the Basel capital standards that once the regulatory authorities finish their weighting scheme, bank managers begin the process of allocating capital and assets to maximize financial returns around these constructed weights,” Hoenig continued. “The objective is to maximize a firm’s return on equity by managing the balance sheet in such a manner that for any level of equity, the risk-weighted assets are reported at levels far less than actual total assets under management. This creates the illusion that banking organizations have adequate capital to absorb unexpected losses. For the largest global financial companies, risk-weighted assets are approximately one-half of total assets.

“In contrast,” he pointed out, “supervisors and financial firms can choose to rely on the tangible leverage ratio to judge the overall adequacy of capital for the enterprise. This ratio compares equity capital to total assets, deducting goodwill, other intangibles and deferred tax assets from both equity and total assets. In addition to including only loss-absorbing capital, it also makes no attempt to predict or assign relative risk weights among asset classes. Using this leverage ratio as our guide, we find for the largest banking organizations that each dollar of assets has only 4 to 6 cents funded with tangible equity capital, a far smaller buffer than asserted under the Basel standards.”

Former FDIC Chairman Sheila Bair seemed to agree with Hoenig and Seamans in a recent Wall Street Journal op-ed. “Regulators need to use a simple, effective ratio as the main determinant of a bank’s capital strength and go back to the drawing board on risk-weighting assets,” she wrote. “It does make sense to look at the riskiness of banks’ assets in determining the adequacy of its capital. But the current rules are upside down, providing more generous treatment of derivatives trading than fully collateralized small-business lending.”

Also in agreement were Sens. Sherrod Brown, D-Ohio, and David Vitter, R-La., who in late April introduced their Terminating Bailouts for Taxpayer Fairness Act. “Regulators would walk away from Basel III,” the senators wrote in their bill summary, “and institute new capital rules that don’t rely on risk weights and are simple, easy to understand and easy to comply with.”

Given the missteps of regulators and bank management leading up to the recent crisis, more capital and more clarity in measuring it are clearly needed.

Bill Poquette is editor-in-chief of BankNews.

Copyright (c) May 2013 by BankNews Media