Former FDIC Chief Bair Calls for Stiffer Rules on Leverage

Former FDIC Chairman Sheila Bair
Sheila Bair, former chairman of the U.S. Federal Deposit Insurance Corp. (FDIC). Photographer: T.J. Kirkpatrick/Bloomberg

Former Federal Deposit Insurance Corp. Chairman Sheila Bair, in testimony to U.S. lawmakers, pushed for stiffer global limits on how much banks can borrow.

The leverage ratio adopted by the Basel Committee on Banking Supervision needs to be increased, Bair told the Senate Subcommittee on Financial Institutions and Consumer Protection. She also urged regulators to consider “starting over” on the language of the Volcker rule as the panel held a hearing today in Washington on “Wall Street megabank risk.”

“Regulators’ primary focus should be constraining absolute leverage through an international leverage ratio that is significantly higher” than the Basel Committee’s proposed 3 percent standard, Bair said in her written testimony.

The European Union has wavered on implementing Basel’s leverage ratio, saying it needs to study the potential impact before committing to it. The U.S. has had its own ratio for about two decades, which would be closely matched by the new Basel standard.

A Basel requirement exceeding 3 percent also would force U.S. banks to boost capital or sell assets. Although the leverage ratio sometimes refers to total assets over equity, Basel and U.S. regulations flip the equation around, talking about equity as a percentage of total assets.

Different Risks

The leverage ratio caps bank borrowing based on total assets on the balance sheet, ignoring the riskiness of different holdings. Standard capital ratios allow less capital to be held against lower-risk assets, giving banks leeway that may allow them to underestimate risk, as they did with mortgage securities before the 2008 housing crisis.

Bair called for an international leverage ratio during the Basel committee’s 2009 to 2010 discussions on new capital and liquidity standards. The committee brings together regulators and central bankers from 27 countries. Its rules aren’t binding on member countries, which need to individually translate the internationally agreed standards into their own regulatory frameworks.

European banks are in worse condition than U.S. peers because capital regulation has been looser and banks more leveraged, Bair said in her testimony. The European banking system is “so fragile” that lenders facing sovereign bond losses can’t raise capital from markets. The EU banks may have to rely on help from the European Central Bank, their governments or the International Monetary Fund, she said.

Options ‘Not Pretty’

“The choices in Europe are not pretty,” Bair said. “They can let a good portion of their banking system fail, or they can commit to massive financial assistance through a combination of ECB bond buying and loans and guarantees from the IMF and stronger euro zone countries. Frankly, I don’t know which is worse.”

Bair also criticized the complexity of the rules drafted by U.S. regulators to implement the Dodd-Frank Act’s Volcker rule. The regulation aims to prevent banks from taking oversized risks with their own capital through trading and investing in hedge funds. Paul Volcker, the former Federal Reserve chairman who conceived the idea, also has been critical of the proposed rules for similar reasons.

“The regulators should think hard about starting over again with a simple rule based on the underlying economics of the transaction, not on its label or accounting treatment,” Bair said. “If it makes money from the customer paying fees, interest and commissions, it passes. If its profitability or loss is based on market movements, it fails.”

‘Personally Accountable’

The new rules also should make bank executives “personally accountable” for monitoring compliance with the standards, Bair said in her testimony.

Asked by members of the Senate subcommittee whether Dodd-Frank had solved the too-big-to-fail issue, Bair said that the authority given to the FDIC to take over and shut down big banks will remove the government backing that the biggest firms have enjoyed for decades. Without that implicit support, shareholders of the banks should force them to break up, Bair said.

Simon Johnson, a finance professor at the Massachusetts Institute of Technology who also testified at the hearing, countered Bair, noting that Wall Street executives are still publicly saying they want to expand globally.

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