Nov. 30 (Bloomberg) -- Bankers generally don't like capital because it's expensive, and they're always looking for ways to get around regulators' rules requiring that they hold it.

That was a key reason why a number of institutions created structured investment vehicles, or SIVs, the off-balance-sheet entities that now have them in so much trouble.

Foolishly, the banks' top executives convinced themselves they had no legal or reputational stake in the SIVs, and that in a world awash in liquidity, it was safe to borrow short and invest long.

Perhaps they were thinking like the late Walter B. Wriston, chief executive officer of Citicorp -- now Citigroup -- for 17 years before he retired in 1984. Wriston always argued that big, diversified banks didn't need to hold much capital.

I remember him standing tall and whip thin in the lobby of the Homestead resort in Hot Springs, Virginia, during a Business Council meeting, lecturing reporters on the point. His bank's earnings came from so many sources in various parts of the world that losses large enough to threaten the institution simply couldn't occur, he declared.

Wriston, who died in 2005, was wrong, of course, spectacularly so.

Fortunately, four years after he retired, regulators in the U.S. and other developed countries overcame bankers' opposition and adopted capital-adequacy rules known as the Basel Accord.

After Citi had major losses on real-estate loans and elsewhere in the early 1990s, Wriston's successor, John Reed, struggled to raise billions of dollars in new capital, as required by the rules.

$7.5 Billion

Another round of losses now has led to a new infusion of $7.5 billion in capital, announced by Citi on Nov. 27.

Without the capital required by the Basel Accord, the current market upheaval might be putting some institutions -- including those ``too big to fail'' -- at risk.

Banking supervisors must be asking themselves why risks inherent in the SIVs didn't get more attention. Specifically: Why didn't the institutions' risk-management systems do a better job?

In the midst of this, U.S. regulators, including the Federal Reserve, on Nov. 2 agreed on rules for the first major update of the original Basel Accord.

Getting the Basel II agreement involved a torturous process of international negotiations amid massive lobbying by different groups of bankers.

Risk-Sensitive Management

In a Nov. 13 speech in New York, Fed Governor Randall S. Kroszner said a purpose of the new agreement was ``enhancing the safety and soundness of the U.S. banking system by providing more-risk-sensitive capital requirements for our largest, most complex banks and improving risk management practices at those institutions.''

Yes indeed, more risk-sensitive management at our largest, most complex banks is needed.

Basel I was outmoded because the rules allowed various types of loans to be put into so-called buckets even when the borrowers had widely different degrees of creditworthiness.

``The enhanced risk-sensitivity of the Basel II advanced approaches creates positive incentives for banks to lend to more-creditworthy counterparties and to lend against good collateral, by requiring banks to hold more capital against higher-risk exposures,'' Kroszner said.

One can only hope that works.

`Financial Innovation'

Charles L. Evans, president of the Chicago Federal Reserve Bank, said in a Nov. 27 speech that the current market turbulence is largely due to ``financial innovation.'' And as was the case in several earlier episodes, such as the impact of the 1970 Penn Central railroad bankruptcy that badly damaged the nascent commercial paper market, no one really understood the risks inherent in the innovation.

``It can take time for market participants to learn how these innovative instruments and practices operate, especially in the event of falling asset prices,'' Evans said.

This time the innovation was the securitization of subprime mortgages in hard-to-understand structured securities that carried more risk than their ratings indicated.

Gary Stern, president of the Minneapolis Fed and author of ``Too Big to Fail: The Hazards of Bank Bailouts,'' wonders whether an element in the creation and temporary success of the SIVs was creditors believing that the Fed wouldn't let a large bank fail.

``Some of these things got created to get around capital requirements,'' Stern said of the SIVs in a Nov. 26 interview. ``That raises questions about risk taking and attitudes about institutions too big to fail.''

``We really don't have any answers at this point,'' he said, adding, ``It certainly would have been nice if the supervisors had spotted these problems, but they can't spot every problem in advance.''

Now the SIVs are beginning to unwind.

On Nov. 26, HSBC Holdings Plc, Europe's largest bank, announced it would allow investors in two of its SIVs with $45 billion in assets to exchange their holdings for debt issued by a new company backed by loans from HSBC.

Others should follow HSBC's lead. And bank supervisors should think long and hard about the fictions they tolerated.

(John M. Berry is a Bloomberg News columnist. The opinions expressed are his own.)

To contact the writer of this column: John M. Berry in Washington at jberry5@bloomberg.net

Last Updated: November 30, 2007 00:46 EST