Are Banks About to Win on Commodities Trading After Their Success in Watering Down Basel III Capital Rules?

You know it’s bad when Bloomberg’s editors attack the banks’ win against regulators, in this case, their success in watering down already-too-generous Basel III capital requirements. And they look primed to score a twofer on pending rulemaking on trading in physical commodities.

One of the hard-fought battles of Basel III was establishing limits on total leverage, as well as risk-weighted leverage. Basel II, which was implemented in Europe pre-crisis, called for risk-weighting of assets. You didn’t count every asset at its face or market value, add that up, and then use that to determine how much in equity a bank had to have as loss reserves; banks had to count only a percentage of the value of assets deemed to be less risky. For instance, the big reason Eurobanks wound up carrying huge holding of periphery country sovereign debt is that it carried a 0% risk weighting. We know how that movie turned out. And in general, that approach wasn’t terribly successful. As former central banker London Banker wrote:

I was looking at the preferred asset classes under the Basel Accords…and realised that every single asset class that is given less than a 100 percent credit risk weighting is now tainted by widespread default, scandals or bailouts.

The credit risk weightings mean that instead of reserving the standard 8 percent of capital in respect of a debt, the bank can cut that by the weighting applied to the asset class. Effectively, the reduction in credit risk weighting operates as a powerful subsidy to the borrowers and equally powerful incentive to over-leveraging the lenders.

The FDIC noticed that the banks that looked well capitalized under these sort of risk weightings (US regulators allowed similar principles to be applied pre-crisis) but had low capital if you used a simple equity versus total assets measure were the most likely to fail. So Sheila Bair, with the support of Dan Tarullo at the Fed, pushed hard and won what sounds like a skimpy requirement for equity to total assets: 3%. But even that meager requirement had the banks grumbling.

And recall that even Timothy Geithner had touted higher capital as the one-stop fix for other shortcomings in regulations. From the Wall Street Journal in 2010:

“The most simple way to frame it is: capital, capital, capital,” Treasury Secretary Timothy Geithner told Congress last year. “You want capital requirements designed so that, given how uncertain we are about the future of the world, [and] given how much ignorance we fundamentally have about some elements of risk, that there is a much greater cushion to absorb loss and to save us from the consequences of mistaken judgment.”

So fast forward and what happened? We turn the mike over to Bloomberg:

This week, the Basel Committee on Banking Supervision, an international group of regulators, announced a number of changes that will make the denominator in leverage ratios — total assets — less simple. Banks will be able to count as little as 10 percent of off-balance sheet commitments, such as letters of credit, as assets. Also, banks can net out cash they borrow and lend against securities in so-called repo agreements, as long as the deals are done with the same counterparty.

There’s a case of sorts for these relaxation… But there’s also a cost: Banks will have more opportunities to understate their assets.

What’s certain is that the changes represent an easing of requirements that were already too loose. The Basel rules require banks to have only $3 in capital for each $100 in assets by 2018 — meaning that a decline of just 3 percent in the value of a bank’s assets could render it insolvent…When capital is so thin, a little manipulation can mean the difference between stability and systemic crisis.

Experience and research strongly suggest that much higher leverage ratios — as high as $20 in capital per $100 in assets — would provide a net benefit by reducing the likelihood of economy-killing financial disasters. The dangers of an undercapitalized banking system have just been vividly demonstrated. Regulators recognized the problem, but they tightened capital-adequacy rules too little. They would do better to show more resolve.

The fact that Bloomberg’s editors are citing the 20% capital ratio, based on the work of Stanford professor Amat Admati, shows that more and more orthodox sources are recognizing the need for way more capital. Too bad the critical players take the banks’ pleadings seriously.

The banks look on their way to scoring another important win on a different front: trading in physical commodities. Most of the financial press is reporting that tougher rules might be in store, due in large measure to pressure by senators led by Sherrod Brown plus media stories of how banks are using their strategic position in storage and delivery to reap large profits at the expense of real-economy users. An important New York Times investigation charged that Goldman was using its large aluminum warehousing operation to inflate inventories, ultimately costing end users $5 billion. So in keeping with official messaging, Bloomberg tells us: Fed Weighs Further Restrictions on Banks’ Commodities Units.

An exclusive report by Shahien Nasiripour of Huffington Post gives a very different picture:

Big banks are poised to reap a significant victory in their fight to maintain lucrative businesses hoarding, selling and trading physical commodities as the Federal Reserve prepares to punt on the issue, people familiar with the matter said.

The Fed’s move to solicit public input on what it should do, rather than use its authority to regulate the activities of large financial institutions, is expected to be announced by Wednesday afternoon in advance of a Senate Banking Committee hearing on the issue. Some federal financial regulators said the move may be a way for the Federal Reserve’s Board of Governors in Washington to evade calls to curb banks’ risk-taking.

Translation: the Fed has the power, now, to tell the banks to cut it out and exit or curtail their participation in the trading of physical commodities (note that former investment banks that are now under the Fed’s purview have physical commodities trading grandfathered for a few years; Goldman cheekily expanded its activities by acquiring a major aluminum warehousing operation that was the focus of the New York Times expose. the Fed blandly permitted it rather than calling out the violation of the intent of the waiver).

By having the Fed rely on the public comments process, it enables the banks to throw their firepower at it, both directly and through all sorts of proxies (friendly think tanks, fake public interest groups). It’s the same sort of concerted effort that enabled banks to score their Basel III win; why shouldn’t the same route be even more successful with a bank-friendy Fed?

The Huffington Post article notes:

It’s likely to stoke criticism that the central bank, while taking some action to reduce the risks large lenders pose to the financial system, is shirking its responsibility to ensure financial stability.

“This is clearly an attempt to avoid dealing with the issues while pushing back against public pressure,” said Joshua Rosner, managing director at independent research firm Graham Fisher & Co….

JPMorgan Chase, Goldman Sachs and Morgan Stanley now are among the nation’s biggest suppliers of energy, according to industry rankings and federal data. Over the last several years, the three banks were among a group of select financial institutions to broaden their physical commodities activities as the sector promised substantial revenues that, coupled with the banks’ traditionally low cost of financing, guaranteed steady and at times enormous profits.

Yet again, it’s important for members of the public to demand that banks operate in the public interest, not for their own outsized enrichment. Being able to use their weight to move commodities markets is one of the a clear-cut transfer from the productive economy to the Wall Street casino. The Fed’s complacency is proof yet again of whose interest it really cares about. Please call your Senators and tell them to come down hard on the central bank for its cravenness.

This piece is cross-posted from Naked Capitalism with permission.