A Bad Way to Make Banks Safe

Layer upon layer.

Photographer: Rogan Macdonald/Bloomberg

Global regulators say they're making progress in reducing the threat that the world's largest banks can pose to the economy. Actually, new rules may be making things worse.

Regulators want to create a second layer of protection against financial disaster, beyond the equity that comprises banks' first line of defense against losses. It would consist of a special kind of long-term debt, issued by financial holding companies to investors willing and able to bear losses.

The idea is that if a big bank came to the edge of insolvency, regulators could convert the debt into equity, using it to shore up myriad subsidiaries around the world without using taxpayer money. In principle, this is fine. In practice, it may not be.

The Financial Stability Board, an international regulatory body, specified that systemically important banks must have a total loss absorbing capacity of at least 6.75 percent of assets (including "bail-in-able" debt and equity). On Oct. 30, the Federal Reserve proposed a higher minimum of 9.5 percent for U.S. banks -- 4.5 percent debt and 5 percent equity. Although the rules won't take effect for several years, Standard & Poor's said that it might cut some big U.S. banks' credit ratings this year, on the grounds that they will be less likely to receive taxpayer support.

This new mechanism has some serious flaws. It won’t be tested until the next crisis comes, so it will take regulators into uncharted territory just when certainty is crucial. Recapitalizing a global institution requires authorities in various countries to cooperate -- something they are unlikely to do, particularly if markets are moving too fast to assess banks' capital needs. Even if such coordination were possible in the case of a single bank, it's hard to imagine it working in a crisis like that of 2008, when many were failing simultaneously.

Capital Requirements

Given the uncertainties, one must ask: How is this better than simply requiring banks to have more equity in the first place? Equity absorbs losses without requiring regulators to trigger bail-ins or strike cross-border agreements. Banks need more of it.

The two-tier system adds complexity and allows banks to keep operating with too little capital. Worse, by requiring banks to issue more debt, it might prompt some to reduce their ratios of equity to assets. This added leverage will leave the system more susceptible to distress in bad times.

True, regulators need a mechanism to deal with big banks that burn through their capital. When pressed, though, they recognize that the bail-in-able debt is needed to compensate for a first layer of loss absorption that's still too thin. To make the system safer, keep things simple.

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