Editorial Board

Rules for Bank Capital Still Broken After Four Years

It has been four years since the global financial crisis first struck, and the system that helped cause the deepest economic slump since the 1930s is still broken.

Sure, laws have been passed and financial rules tweaked; the U.S., for instance, in 2010 approved the wide-ranging Dodd-Frank law. But a critical component of a stronger financial system -- an internationally coordinated increase in bank capital -- is missing.

U.K. and European Union finance ministers over this last week. And it’s already clear that the new capital-adequacy rules, when finally in place, will be too weak.

International regulators are debating how to implement the accords, known as Basel III (after the Swiss city where agreements on how banks should be funded are often negotiated). The previous system, Basel II, totally failed. It required too little capital and let banks invest in some risky securities, including sovereign debt, as though they were risk-free. This helped bring on the financial meltdown. Sadly, the new rules on capital are only a small improvement -- and that’s assuming they aren’t further watered down in the implementation.

Wafer-Thin Capital

Bank capital is of paramount importance because it is capable of absorbing losses. If a well-capitalized bank gets into trouble, its shareholders suffer, but depositors, the taxpayers who insure their deposits and the rest of the financial system are protected. Wafer-thin capital -- in other words, huge leverage -- was the main reason the crash propagated as it did.

The new accord proposes that banks maintain equity capital of 4.5 percent of risk-adjusted assets, plus a 2.5 percent added buffer. Equity of 7 percent is an improvement over Basel II, but still far less than needed. Even under the new regime, some supposedly risk-free assets would require little or no capital backing, so equity as a proportion of total assets would be lower. Basel III sets a floor of just 3 percent for equity as a proportion of total assets. A much higher figure -- as high as 20 percent of assets -- is called for.

When figures like that are mentioned, bankers recoil in horror, and governments fall for it every time. If banks had to set so much capital aside, they say, they wouldn’t be able to lend as much -- and governments surely want them to lend?

This is a fallacy, as finance scholars keep explaining. (If you want clarity on this point, read this paper by Stanford’s Anat Admati.) Capital isn’t “set aside.” It’s a source of bank funding, not a use of bank funding. Telling banks to raise more equity does not limit their capacity to lend.

It does reduce returns to bank shareholders. But if banks are safer -- and making them safer is the whole point -- the return on their equity should be lower. And some of the return enjoyed by banks’ owners reflects the implicit subsidy that taxpayers hand over to banks deemed “too big to fail.” By making banks safer, extra capital reduces the value of this subsidy, and hurts banks’ profits. Again, that’s a good thing.

Because Basel III is too weak and on track to fail, international regulators should ideally start over, but that isn’t going to happen. The crucial thing now is for national regulators to see Basel’s requirements as a minimum (which, technically, they are) and go much further unilaterally. The U.K., among other things, wants to keep the power to apply stricter standards than Basel III (as interpreted by the EU) would require. Unpopular as this may be in Europe, the U.K. is right to insist.

Banks Push Back

Banks everywhere will push back against the idea that Basel III is just a start. If the U.S. sets much tougher capital rules than other countries, its banks will complain that they have been put at a competitive disadvantage and will demand a level playing field.

In a way, they’ll be right. A level playing field would be good. But if international coordination produces a bank-capital regime that continues to subsidize banking and is far too weak -- and that’s how things are shaping up -- the choice for national regulators is clear. They can have safe banks that operate at some competitive disadvantage or unsafe banks that compete on level terms. Reflect for one moment on the costs of the recession, and the choice is easy.

    To contact the senior editor responsible for Bloomberg View’s editorials: David Shipley at davidshipley@bloomberg.net .

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