The Wrong Way on Bank Risk
Regulators have been working hard to make new global capital rules more palatable for banks. They should now raise the minimum requirements high enough to make the risk of financial disaster more bearable for everyone else.
At issue are leverage ratios, which regulators around the world are increasingly using as a way to ensure that large banks finance themselves with a minimum amount of loss-absorbing equity. As opposed to risk-weighted capital ratios, which typically rely on big banks to assess the riskiness of their own investments, leverage ratios offer a simple measure of capital as a percentage of total assets. They make it harder for banks to manipulate their capital ratios into meaninglessness.
This week, the Basel Committee on Banking Supervision, an international group of regulators, announced a number of changes that will make the denominator in leverage ratios -- total assets -- less simple. Banks will be able to count as little as 10 percent of off-balance sheet commitments, such as letters of credit, as assets. Also, banks can net out cash they borrow and lend against securities in so-called repo agreements, as long as the deals are done with the same counterparty.
There’s a case of sorts for these relaxations. They might make banks more willing to provide lines of credit to facilitate trade, for example, or help businesses get through difficult times. Investors might find it easier and cheaper to buy and sell securities if traders are freer to use repo financing. But there’s also a cost: Banks will have more opportunities to understate their assets.
What’s certain is that the changes represent an easing of requirements that were already too loose. The Basel rules require banks to have only $3 in capital for each $100 in assets by 2018 -- meaning that a decline of just 3 percent in the value of a bank’s assets could render it insolvent. A rule under consideration in the U.S. would go a bit further for bank-holding companies, requiring $5 of loss-absorbing capital for $100 of assets. When capital is so thin, a little manipulation can mean the difference between stability and systemic crisis.
Experience and research strongly suggest that much higher leverage ratios -- as high as $20 in capital per $100 in assets -- would provide a net benefit by reducing the likelihood of economy-killing financial disasters. The dangers of an undercapitalized banking system have just been vividly demonstrated. Regulators recognized the problem, but they tightened capital-adequacy rules too little. They would do better to show more resolve.
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