This weekend’s Bloomberg view column seems to have generated some controversy.
Let’s look at what the column says:
The Basel III banking rules … require banks to finance their activities with more equity, or capital, as opposed to debt. The equity helps guarantee that the bank’s own shareholders will absorb any losses, instead of turning to taxpayers for bailouts.
As we have said before, not quite. More capital helps a bank absorb losses in insolvency (or resolution). It does not help to absorb losses on a going concern basis, as this capital is not available for that purpose.
the capital requirements aren’t terribly burdensome. For the biggest banks, including JPMorgan Chase, they amount to somewhere between 3 percent and 5 percent of assets
I suppose ‘burdensome’ is a matter of judgement. But what isn’t is the gap between where banks are now and where they will need to be post Basel 3. The gap is hundreds of billions of dollars. So who, exactly, is going to buy all this news bank equity knowing that their returns will be capped in the single digits by regulation?
To be fair to Bloomberg, they have an answer:
Average U.S. wages in finance are about 70 percent higher than in other industries. Erasing that compensation gap—it didn’t exist 30 years ago—would cut operating costs just about enough to raise a typical bank’s capital ratio from 5 percent to 10 percent without increasing lending rates and without impairing shareholders’ profits.
So the suggestion is that the extra core Tier 1 capital will come from retaining more earnings and paying bankers less. I don’t find that particularly objectionable. But for it to work, the banks do actually need to make enough money that they can retain sufficient earnings to raise their capital bases. This is by no means certain. Worse, it provides a bigger incentive to concentrate on the most profitable business at the expense of important but dull activities; like, err, SME and middle market lending. And that, in this worryingly bad economy, might not be a good thing. Banking reforms like this should be implemented when times are good.
The best research available, from a group of researchers led by former Morgan Stanley (MS) economist David Miles, has found that even extremely high capital ratios—as high as 50 percent—would actually be good for the economy, because the benefit of reducing the frequency of financial disasters far outweighs any costs. Optimal capital would probably be about 20 percent of risk-weighted assets, equivalent to tangible equity of 7 percent to 10 percent. That’s double the level in Basel III.
Who says that this ‘is the best research available’? In particular, does this research assume that higher capital is actually available to absorb losses? If so, what mechanism do the researchers propose by which a capitally inadequate but solvent bank will retain the confidence of the funding markets for long enough to survive through a crisis?
The [Basel] risk-weighting system is also far too complex and too easily manipulated to provide a reliable picture of how much capital a bank really has. For a large bank such as JPMorgan, coming up with a risk-weighted ratio requires sorting assets into more than 200,000 different buckets. Even unintentional errors can skew reported capital ratios by several percentage points. That’s a problem when the starting point is only 10 percent.
‘Several percentage points’ is a high, but I will agree that RWA mitigation can materially affect a capital ratio. But when we are at 10% anyway, and there are backstops such as the leverage ratio and stress testing, that should not be a major concern.
Bloomberg suggests that not to ‘go far beyond Basel’ in imposing capital requirements would ‘truly be anti-American’. I disagree. America has a self image that includes the promotion of innovation and a healthy economy. You can’t do either without a functioning credit system. Much higher minimum capital requirements would further stiffle credit and do little for financial stability.