Banks Need More Capital, Not a New Rulebook

At 1,087 pages, a recent proposal to change capital rules would surely make life more complicated for big US banks. But will it make them safer?

The failure of three regional banks starting in March was an embarrassment for regulators, who had assured taxpayers that reforms put in place after the 2008 financial crisis had made the system much more resilient. The new proposal attempts to extend those reforms in light of the recent turmoil.

It recommends a few useful fixes. Recognizing that even regional lenders can cause risks to the entire financial system, regulators will now require banks with assets between $100 billion and $250 billion to comply with many of the tougher rules already applied to their bigger rivals. The proposal also revises a rule that had allowed those banks to opt out of counting unrealized gains and losses on some of their investments when calculating their capital ratios.

The heart of the proposal is a change to how capital is measured. Currently, banks can use their own models to assign risk-weightings to their assets, which determine how much capital they need. That allows different banks to measure the risk of the same loan differently, making it hard to compare capital adequacy across the system. More important, banks have an incentive to underestimate risk and boost leverage as they seek to maximize their return on equity.

Now regulators want to assign new standardized risk weightings instead. Much of the proposal explains how they plan to calculate the credit risk of particular assets and quantify the danger of operational losses. Trading desks can independently determine the risk of losses from market movements, but only if they use approved models. As a result of these and a few other requirements, regulators estimate the largest banks would need about 19% more capital and the biggest regionals will need as little as 5% more. Given that US banks remain overleveraged, this outcome would be progress of a kind.