Bank Capital Standards Revisited

After many years of labor and many, many drafts, the Basle Committee has come up with a proposal for new and very different capital standards for “international banks.”

The standards used by almost all banks around the world were essentially created by the Basle Committee back when I chaired the FDIC. The standards were fairly simple and were designed for the same “international” banks. I participated in this exercise, and it took us (representatives from about 25 countries) two or three days to come up with the present world standards (8% of risk-weighted assets).

However, the Basle Committee felt that these “back of the envelope” rules were not enough to govern today’s complex financial system, which commonly involves derivatives and other hybrid financing structures; hence, the push for a new design.

The new rules are infinitely complicated, but essentially they require a bank to build computerized models that measure different categories of risks (i.e., interest rate, exchanges, country, etc.). The results of these models will determine the individual capital-level guidelines that are required for each institution. Interestingly, this exercise will result in the big banks generally having to hold less capital than under current rules.

If you are familiar with capital guidelines for Fannie Mae and Freddie Mac, the great home mortgage securitizers, you know that they employ this kind of computerized model. It results in capital-level requirements that are much lower than current bank rules, but it also provides a stress test that requires them to maintain capital to meet the needs for their worst year in modern history.

So, why should community bankers be interestedu00e2u20ac”and perhaps concernedu00e2u20ac”about new standards for international banks that do not apply to them?

There are several reasons.

First, the previous standards initially were designed for international banks, but soon were adopted for all banks. The new Basle Committee guidelines will undoubtedly follow this standard-setting trend. If so, community banking expenses will go up as models are required to be built and regulators set individual capital targets. For community banks, this could be a costly exercise.

Second, as FDIC Chairman Powell has pointed out in a recent letter to the Fed (which naturally has the lead in this exercise and strongly supports the Basle Committee), the result of the new standards will be to nearly always set capital requirements lower than under present rules. This new standard could be a huge cost to the FDIC if lower capital requirements produce larger losses for the BIF fund. Of course, if that happens, all the banks will pay for the reduced capital requirements of the so-called “international” capital rules.

Third, banking is a competitive combat sport, and reducing the capital-level requirements on international banks means they will have a competitive advantage. In the U.S., at least, international banks (i.e., Bank of America, J.P. Morgan Chase, Wells Fargo) compete in many financial areas with community banks. Given that the “international” standards are set by the banks themselves, they’ll not likely err on the side of requiring more capital. Trying to deal with this potential advantage, especially at the margin (the first large bank that is not considered international) will be nearly impossible.

Finally, these regulations are infinitely complex and will require large amounts of supervision. The present rules can be tweaked to adjust for known and proven problems. But, these rules have served us well for 20 years. So, in my opinion, if it ain’t broke, don’t fix it.