Editorial Board

Banks Need Capital, Not Complexity

In regulating banks, it's best to keep it simple.

A source of stability.

Photographer: Louisa Gouliamaki / Getty Images

Global financial regulators are still at work on rules aimed at ensuring that the world's most systemically important banks can weather a crisis without sinking the economy. They've made some progress -- but they're also making things too complicated.

Regulators are trying to create a double buffer against financial disaster. The first layer is equity, the only kind of financing that can absorb losses in bad times. The second is debt that can be "bailed in" -- meaning converted to additional equity -- if losses become too great. The goal is to raise banks' total loss-absorbing capacity to as much as 25 percent of assets, weighted by risk.

QuickTake Too Big to Fail

The plan isn't going well. An analysis by Bloomberg has shown that it's too easy on institutions with big trading operations, whose safety is especially important. The rules ignore such banks' dependence on fragile, short-term financing and don't allow for the fact that they are particularly good at using risk weights to shrink their assets. (At Deutsche Bank AG, a loss-absorbing capacity of 25 percent of risk-weighted assets would be equivalent to just 6 percent of total, unweighted assets.)

To make things worse, the process for bailing in debt is untested. If a big cross-border bank runs into trouble, newly created equity is supposed to help the home-country regulator shore up confidence by recapitalizing subsidiaries across the globe. For this to work, foreign regulators would need to cooperate rather than seize assets to protect local creditors -- which is unlikely. And the bailed-in debt would need to have been issued by a single holding company -- which euro-area banks typically don’t have.

QuickTake The Volcker Rule

The second layer of bank defense is therefore too weak. Some regulators recognize this. U.S. Federal Deposit Insurance Corp. Vice Chairman Thomas Hoenig, for example, has expressed doubt that the system could handle a crisis like that of 2008, when many banks ran into distress at once. It’s a second-best solution tasked with compensating for a first layer that's too thin. At just 3 percent of total assets (5 percent in the U.S.), minimum equity requirements still fall far short of what’s needed to ensure that banks would be a source of strength in a crisis, rather than the decisive point of failure.

Regulators do need a way to deal with banks that burn through all their capital. A good defense system, though, should first aim to make that eventuality as unlikely as possible. There's a straightforward way to do that: Require banks to finance themselves with much more equity. When it comes to regulating bank capital, simple is best.