Why So Hard to Make Banks Boost Capital?

Just about everyone agrees: Banks need to hold more capital. So why are so many predicting little real progress on that front at the G-20 summit?

For one thing, bank leverage is already down, and regulators are presumably keeping an eagle eye on capital cushions, says Stephen Auth, head of equity investment for Federated Investors, the big money manager based just blocks from the main G-20 venues in Pittsburgh. So the danger is no longer so imminent.

"While certainly they're focusing in there on one of the key issues, as we all know, it's a little like closing the barn door after the cows are out," Auth told BusinessWeek.

But it's a big step from saying banks should hold more capital to deciding how much more they should hold. Basel II, the international bank-capital standard that was kicking in as the financial crisis exploded, took years to implement. Part of the fuss: European banks tend to be more heavily leveraged than American ones, so Europeans generally aren't interested in going as far as U.S. officials would like. They also want the U.S. to adopt Basel II before coming up with a newer standard. U.S. policymakers, though, aren't convinced Basel II is rigorous enough, and they like their own system of adding a flat cap on a bank's overall leverage to supplement rules that let banks hold more capital, or less, depending on how risky the assets are.

Areas of Agreement What's so striking about the international difficulties is that, at least so far, capital rules aren't all that controversial in the U.S. Congressional leaders seem inclined to leave matters to banking regulators, who already have most of the tools they need to tighten the screws.

But international coordination is seen as critical. If one country clamps down and others don't, the fear is it will leave the tougher country's banks at a competitive disadvantage. There's a strong incentive for countries to cooperate in setting rules (and, some argue, to later cheat and loosen their own rules, giving their own banks an advantage).

Still, progress is afoot. Earlier in September, in London, the G-20's finance ministers set out some broad areas of agreement, including implementing Basel II, raising capital levels generally, requiring more of a bank's capital to be higher-quality, and holding banks to higher standards in good times so there's more of a cushion when conditions deteriorate.

The G-20 heads of state in Pittsburgh are likely to sign off on that, analysts say. "But we do not believe there will be any new or significant announcements about new initiatives or how the previously stated goals will be attained," Brian Gardner, a financial policy analyst for Keefe Bruyette & Woods, said in a note to investors on Thursday. "We think there is broad agreement on most of these issues, especially on bank capital standards, but executing these goals will, in our view, be difficult."

The Effect on Credit One thing that shouldn't hold them back, argues former JPMorgan (JPM) investment banker and Brookings Institution fellow Douglas Elliott: Fear that raising capital standards will limit the credit available to borrowers.

In a study posted online on Sept. 24, commissioned by the Pew Financial Reform Project, he concludes that, "while not free," raising the amount of common equity held by U.S. banks substantially may well only lower loan volumes slightly. Banks can make relatively minor adjustments to keep their return on capital from suffering badly, allowing them to raise even relatively large amounts of new capital if given enough time, Elliott says in the report.

"[B]anks do have a variety of levers to pull, which should allow them to make the transition," Elliott writes. "[T]he U.S. banking industry could adjust to higher capital requirements on loans through a combination of actions that would not wreak havoc on the system."

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