Basel III Was a Big Bust

Basel III Was a Big Bust

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Banks didn’t need the Basel Committee to tell them to keep more capital on their books.  They already had it.
Everyone’s talking about Tier 1 capital.  But don’t be off put if you don’t know what Tier 1 capital means.  It’s simply the sum of a bank’s common stock and other qualifying financial instruments, as defined by the Bank for International Settlements.  When taken as a percentage of risk-weighted assets, you get the Tier 1 capital ratio: a measure of a bank’s financial strength.  In other words, a higher Tier 1 capital ratio is an indicator of a more financially resilient bank.  However, if this ratio is too high, it may be a sign that a bank is not taking on enough risk, for example not lending enough of its money to consumers and businesses.

On Sunday, the Basel Committee on Banking Supervision outlined a new, stricter set of capital standards for banks.  Among these new standards is a requirement to raise the minimum Tier 1 capital ratio to 6 percent from 4 percent. It also introduced the idea of adding 2.5 percent as a “conservation buffer,” to be drawn from “during periods of financial and economic stress.”  The buffer effectively brings the new Tier 1 capital ratio requirement to 8.5 percent. By raising these ratios, the committee believes it is promoting a more resilient banking system.

But the banks aren’t stupid. Many are way ahead of the regulators.  Since the crescendo of the financial crisis, banks have been beefing up their balance sheets.  At the end of the second quarter, J.P. Morgan, Bank of America, Wells Fargo, and Citigroup reported Tier 1 capital ratios of 12.1 percent, 10.7 percent, 10.4 percent, and 12.0 percent, respectively.  Among the big investment banks, Goldman Sachs had a 15.2 percent ratio and Morgan Stanley boasted a 16.4 percent ratio. (All figures taken from each banks’ respective second quarter earnings announcements.)

Then again, former Lehman CEO Dick Fuld recently reminded us that Lehman Brothers boasted an 11 percent Tier 1 capital ratio just days before it went belly up.  If 11 percent wasn’t sufficient two years ago, why would it be today?

To be fair, the Basel Committee has bigger plans for the bigger banks. It said, “Systemically important banks should have loss absorbing capacity beyond the standards announced today and work continues on this issue.”  It cites “capital surcharges, contingent capital and bail-in debt” as possible ways to reduce the risk of a big bank failure.

It’s admirable that regulators are trying their best to prevent another Lehman-like failure.  Combined with the other Basel accords, the financial system may be more robust than it was before. However, it is unlikely to be able to handle the type of panic we saw in the fall of 2008, when asset values collapsed and everyone pulled their money out of everything.

No matter how hard you try to prevent it, banks will fail.  Small banks fail frequently with little fanfare. Last Friday, the FDIC closed its 119th bank of the year.  Unfortunately, big banks fail too, and the world now knows that some banks are too big to be allowed to fail. 

Regulators must tackle the risk posed by systemically important, too-big-too-fail banks. They could eliminate the risk by breaking up these institutions into banks small enough to fail. At the very least, they must create a clear plan in the event of a too-big-to-fail bank failure.

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