Banking’s New Four Letter Words

Over the next several years, the largest U.S. banks will be required to raise hundreds of billions of new capital on top of the billions they’ve already raised since the global financial crisis of 2008. The Basel III Accord, an international agreement that will be phased in over a two-year period once it has been adopted by financial regulators in this country, would raise the minimum requirement for common equity and Tier 1 capital, and also tighten the definition of what qualifies as Tier 1. Large banks also will be required to maintain an additional layer of capital-it could be as much as 2.5 percent-as an extra buffer against losses.

Basel III will apply primarily to the country’s largest banks, although the reality on the ground is that institutions of all sizes are being required to meet higher capital standards by their prudential regulatory agencies. The logic of higher capital ratios is so universally accepted that few dare challenge it. The country’s biggest banks have argued against Basel III’s 2.5 percent surcharge in private, but their public opposition has for the most part been muted with the exception of J.P. Morgan Chase & Co. CEO Jamie Dimon, who has been making a big stink about it to no avail.

Banking has a new four-letter word, and it’s spelled R-I-S-K. Ever since the late summer of 2008, when the failure of Lehman Brothers brought the global capital markets to its knees, there has been a tremendous amount of focus on taking risk out of the banking system. This attempt to tame risk (or at least better contain it) is reflected in Basel III, and also in the landmark Dodd-Frank Act, and is driven by another four letter word, F-E-A-R.

Although we can debate how much is too much, requiring banks to hold at least some higher level of capital is a good idea. But will higher capitalization standards alone make the banking system safer and stronger? Lehman Brothers was filled with so many toxic mortgage securities that no amount of capital could have saved it from bankruptcy. The same is probably true of two other high-profile casualties of the 2008 crisis, Countrywide Financial Corp. and Washington Mutual Inc. The greatest damage that occurs when a large bank fails during an economic downturn (which is, after all, when large banks fail) is not to the FDIC’s Bank Insurance Fund; it’s the concussive impact that a high profile failure can have on the entire financial system, especially during a recession when the collective market psyche is already fragile. This clearly is what happened in 2008 when the U.S. government declined to rescue Lehman and the firm collapsed. No amount of capital can prevent a global panic that is driven by fear.

Have we forgotten that risk is inherent in banking (as in all of life)? Not only can risk not be eliminated, it shouldn’t be. Without risk, there’s no possibility of a return, and a capitalistic economy can’t function properly without an upside. Under certain scenarios, the required level of capital under Basel III for a large bank could be as high as 13 percent of risk weighted assets! I do wonder how any bank could make a decent return for its shareholders with that much capital. Large banks might be required by law to raise more capital, but institutional investors aren’t required by law to give it to them-and they won’t if they don’t see the prospects of a good return on their money.

It seems to me that two things are required to ensure the safety and soundness of a bank. Capital is one, but another is a sophisticated risk management system that identifies emerging risks early enough in the game that the senior executive team and the board of directors (and the regulators) can do something about them. I hear a lot of talk about capital, but not so much about risk control. Risk management practices vary from bank to bank. Some are good at it. Many aren’t. It’s safe to say that Countrywide and Washington Mutual had dysfunctional risk cultures that no amount of capital could have compensated for.

The Collins Amendment in the Dodd-Frank Act required the federal banking regulators to establish minimum capital standards for all U.S. banks, which they did this summer. If only it had also directed the regulators to develop minimum standards for risk control depending on the size of bank and its mix of business. Through September 30 of this year, there have been at least 396 bank failures in the United States since 2008, and I’m betting that many of them would have ended up just as dead with an extra 2 percent capital parked on their balance sheets. It’s time for the industry to elevate its risk control capabilities to another level. Requiring banks to have more capital without sharpening their risk management skills is D-U-M-B.