Amidst growing calls from noted banking regulators and the nation's community banks, U.S. Sens. Sherrod Brown (D-OH) and David Vitter (R-LA) are urging the U.S. banking agencies to simplify and strengthen new bank capital standards. With the U.S. beginning to implement the Basel III international capital standards, Brown and Vitter urged the Federal Reserve, the Office of the Comptroller of the Currency (OCC), and the FDIC to abandon the overly complex approach of the Basel II accord, and to focus on higher and more loss-absorbing capital buffers. Recently, Tom Hoenig of the Federal Deposit Insurance Corporation (FDIC) and Andy Haldane of the Bank of England have called for such action.
"Wall Street banks have become too large, while their capital requirements are too small. And both these institutions and their rules are so complex that no one--not their executives, nor their shareholders, nor their regulators--truly understand their financial health," Brown said. "It is essential that banks fund themselves with more pure equity, so that taxpayer dollars are not on the line, and capital rules should be simple enough that banks of all sizes can understand them."
"This is not complicated finance. If a huge bank wants to provide loans and investments for billions of dollars, then they should be required to keep a certain amount of reserves on hand to absorb any rapid or sudden market turns," said Vitter. "They certainly shouldn't empty their bank vaults, fail and then turn to the federal taxpayer for a bailout because they didn't keep some emergency savings. Louisiana families certainly have to keep emergency savings -- why shouldn't these megabanks?"
In August, Brown and Vitter, who are both members of the Senate Banking Committee, sent a letter to the Federal Reserve urging the agency to raise the capital requirements for the largest megabanks, in order to alter the incentives of "Too Big to Fail" megabanks.
The full text of the letter is below.
Dear Chairman Bernanke, Chairman Gruenberg, and Comptroller Curry:
There is bipartisan consensus among members of the Senate Committee on Banking, Housing, and Urban Affairs that it is appropriate to require banks to fund themselves with equity sufficient to withstand significant economic shocks. With financial regulators considering a host of new domestic and international capital requirements, we write today to urge your agencies to simplify and enhance the capital rules that will apply to U.S. banks. Simpler, more robust capital rules will benefit smaller banks by lessening their regulatory burden; properly align incentives for megabanks by lessening government support for the financial sector; and reassure financial markets that the U.S. financial system is healthy.
The Basel Committee has proposed requirements of a 4.5 percent Tier 1 Common Equity risk-based capital ratio (plus a 2.5 percent capital conservation buffer to avoid capital distribution restrictions), with an additional proposed surcharge between 1.0 percent and 2.5 percent for systemically important banks. The proposal also contains a 3 percent Tier 1 capital leverage ratio.
This proposal is an improvement over the existing Basel II framework, but unfortunately, we are concerned that this proposal will still not be sufficient to prevent another financial crisis. These standards are considerably lower than the Basel Committee's conservative estimate of the optimal capital ratio of 13-14 percent. Global banks hold assets with average risk-weighting of 40 percent, meaning that the 10 percent risk-weighted Basel III ratio would amount to leverage 25 times their equity. Were a megabank's assets to decline by 4 percent under that scenario, it would become insolvent.
We agree with FDIC Board Member Thomas Hoenig that Basel III's continued focus on risk-based capital ratios are "overly complex and opaque." As you begin implementing these standards, we urge you to focus on simplifying these rules, with a focus on pure, loss-absorbing capital. This will strengthen mega banks' balance sheets, protect taxpayers, reassure investors, and reduce the regulatory burden on the community banks that are already better capitalized than Wall Street banks. In this case, simpler really is better.
The largest U.S. financial institutions have become remarkably complex. This complexity inhibits corporate executives or regulators from properly executing their oversight responsibilities, making management, much less calculation of the proper capital standards, next to impossible. For example, the six largest banks currently have a combined 14,420 subsidiaries, and the Federal Reserve Bank of Kansas City estimates that it would require 70,000 examiners to study a trillion-dollar bank with the same level of scrutiny as a community bank. It is no wonder then that former executives have admitted that it is impossible to fully understand all of the positions that trillion-dollar megabanks are taking. Sallie Krawcheck, the former head of wealth management at the nation's second-largest bank, recently said that this level of complexity, "makes you weep blood out of your eyes[.]"
Institutional complexity has grown hand-in-hand with regulatory complexity. Morgan Stanley Chief Economist Vincent Reinhart told the Senate Banking Committee that "balance sheets of large firms have been splintered into a collection of special purpose vehicles, and securities have been issued with no other purpose than extracting as much value as possible from the Basel II Supervisory Accord." The Bank of England's Andy Haldane has estimated that an average large bank would have to conduct more than 200 million calculations in order to determine their regulatory capital under the Basel II framework.
Basel II also relied upon banks' internal modeling. According to Reinhart, "the reliance of self-regulation inherent in the Basel II supervisory agreement can be seen as an official admission of defeat: a large complex financial institution cannot be understood from outside." The reliance on internal modeling then gives large institutions an opportunity to use models to game capital standards. Adjusting between the standardized and internal-ratings-based approaches to risk weighting can alter a bank's capital ratio between 0.5 and 1.0 percentage points.
Haldane argues that this complexity and opacity provides limitless arbitrage opportunities. Risk-weighting can obscure banks' true capital situations, distorting the views of markets and regulators, and undermining confidence. In 2007, the 10 largest banks had average risk-based capital ratios of 11 percent, but tangible equity ratios of about 2.8 percent.
Banks may have to calculate several thousand factors to determine its value at risk (VaR), and then several thousand default and loss scenarios, meaning that there could be a range of several million scenarios arising from a large bank's trading book. Haldane describes the remarkable variation between results when the UK's Financial Services Authority (FSA) asked banks to determine their regulatory capital based upon a hypothetical portfolio:
The range of reported capital requirements held against this common portfolio was striking. For wholesale exposures to banks, capital requirements differed by a factor of over 100%. For corporate exposures, they differed by a factor of around 150%. And for sovereign exposures, they differed by a factor of up to 280%. Those differences could equate to a confidence interval around reported capital ratios of 2 percentage points or more.
When such a variation arises between banks' self-reporting results for their risk-based capital is combined with a system that relies upon banks' internal modeling, markets will lack confidence in these institutions' capital measures.
Another key failing of Basel II was its reliance on a risk-weighting system that inaccurately assigned safe ratings to instruments such as pools of mortgages. Banks were able to use so-called "riskless" mortgage securitizations to arbitrage regulatory capital standards. The Swiss bank UBS illustrates the shortcomings of previous capital regimes. UBS Investment Bank retained the super-senior tranches of mortgage-backed security collateralized debt obligations (CDOs) and avoided capital charges by engaging in credit default swaps against the credit risks of these securities. UBS's risk-weighted assets were nearly one-sixth of their gross assets; in reality, they had less than 2 percent capital. These transactions were not actually riskless -- in fact, some amplified risk within the system, creating a "daisy chain" of potential defaults. In October 2008, the Swiss National Bank committed $60 billion to save UBS.
There are indications that things may not change significantly under Basel III. There are reports that European banks plan to engage in a practice called "risk-weighted asset optimization," altering their risk calculations for regulatory capital. In the U.S., banks have said that they will "manage the hell out of R[isk] W[eighted] A[ssets]."
Simplified Equity and Leverage Requirements Are Required
The answer is not more and more complex capital regulations. Haldane has found that simple measures of equity and leverage actually have predictive value that is ten times greater than that of complex risk-weighted asset measurements. The case of UBS shows that complexity may in fact make the financial system more fragile and sensitive to shocks.
Simpler, more robust capital rules will benefit smaller banks and properly align incentives for megabanks. First, simplifying capital and leverage calculations will benefit small banks that lack large legal and compliance divisions, but are nonetheless facing a deluge of new rules pursuant to Dodd-Frank and Basel III.
Second, community banks evaluate their capital positions within the constraints of a free market economy. If they fail, they will be put through the FDIC resolution process. But the largest banks enjoy protection from a "safety net" -- a variety of implicit guarantees that their profits will be enjoyed by privatize parties and the costs will be paid by society. Dr. Hoenig has noted that the government safety net allows large banks to be undercapitalized relative to their community bank competition. In 2009, the 20 largest financial institutions on average funded themselves with a mix of 3.5 percent equity capital, as compared to an equity to capital ratio of 6 percent held by the second tier of institutions. Were the largest banks to meet the 6 percent benchmark, they would be forced to raise $300 billion in capital, shrink their balance sheets by $5 trillion, or some combination thereof. Equity funding is an essential tool for lessening government support for the financial sector at levels that would be adequate in the absence of the safety net.
Finally, clear capital standards will reassure financial markets. Accounting gimmicks may help institutions appear to have higher regulatory capital levels and avoid raising more equity, but when risk weights are gamed, the markets lose faith in banks' balance sheets. During the crisis, the markets were not reassured by the allegedly healthy Tier 1 capital ratios at the largest Wall Street institutions. Markets ignored certain instruments that qualified as Tier 1 capital but were not reliable buffers against loss. Instead, market participants were primarily concerned with whether institutions had sufficient levels of common equity.
We support Dr. Hoenig's view that regulators should focus on the level of pure tangible common equity at financial institutions. Governor Mervyn King and the Bank of England have also advocated a pure leverage ratio to backstop capital requirements and ever-changing risk weights. Former FDIC Chairman Bair has noted that European banks are less well capitalized than U.S. banks because they have no required leverage ratios and rely on Basel II's internal models that treat sovereign debt as riskless. But the levels contained in the Basel proposal are too low. Three percent allows institutions to take on 33 dollars in debt for each dollar in equity. Haldane estimates that the largest banks would have need a minimum of seven percent leverage to have survived the financial crisis.
We agree with Dr. Hoenig that capital rules should be "simple, understandable and enforceable." And they should be sufficient to withstand the next financial crisis.
Thank you for considering our views on this important matter.