Mirable Dictu! U.S. Regulators Impose Tougher Rules on Bank Capital

It’s easy to be cynical about the state of bank regulations, since the regulators themselves have for the most part been badly captured by the industry. So it’s important to give them credit when they take a meaningful step in the right direction.

Readers of Sheila Bair’s book Bull by the Horns may recall that one of her big fights was to implement a simple leverage ratio as the test of the adequacy of bank capital. Of course in banking nothing is simple; we’ll get to some of the complexities in due course. The original Basel accords, and Basel II, which had been implemented in Europe before the crisis and went live in the US in 2008, allow banks to risk weight their assets for the calculation of how much capital they need to hold against it. Certain assets, like sovereign debt, carried a zero risk weight (as in banks had to hold no capital against it) and AAA mortgage securities had a low risk weight. Guess what banks loaded up on?

Bair determined that banks that looked to have a decent level of capital per the Basel accords but were highly levered when measured by a simple equity to total assets ratio were the ones most likely to fail. She enlisted the Fed’s Danny Tarullo to campaign for a simple leverage ratio. They got 3% into Basel III, which was better than nothing but short of what they wanted.

Remarkably, today the Fed, FDIC and Office of the Comptroller of the Currency announced that the US was implementing a 5% simple leverage ratio for big bank. From the OCC’s press release:

The final rule applies to U.S. top-tier bank holding companies with more than $700 billion in consolidated total assets or more than $10 trillion in assets under custody (covered BHCs) and their insured depository institution (IDI) subsidiaries. Covered BHCs must maintain a leverage buffer greater than 2 percentage points above the minimum supplementary leverage ratio requirement of 3 percent, for a total of more than 5 percent, to avoid restrictions on capital distributions and discretionary bonus payments. IDI subsidiaries of covered BHCs must maintain at least a 6 percent supplementary leverage ratio to be considered “well capitalized” under the agencies’ prompt corrective action framework. The final rule, which has an effective date of January 1, 2018, currently applies to eight large U.S. banking organizations that meet the size thresholds and their IDI subsidiaries. The final rule is substantively the same as the rule proposed by the banking agencies in July 2013.

And perhaps more important, their notion of what has to be counted in determining the level of total balance sheet exposures is more comprehensive than the version the Europeans are using. And the simple leverage ratio is 6% in the banks’ federally insured depositaries, which is where they’ve chosen to park risky derivatives positions.

Moreover, the difference between the more permissive European view of what gets counted as a balance sheet exposure and the US posture is not trivial. Matt Levine at Bloomberg looks at Morgan Stanley, the bank that will come up the most short despite having Tier 1 capital of 7.3% relative to its audited financials. But that’s not how regulators look at it:

Thinking about the actual size of a bank’s assets will lead to madness. There’s nothing actual about a bank. A bank is a pure creature of accounting; how much of it there is depends entirely on what you are trying to measure. One form of measurement is U.S. generally accepted accounting principles, which have their purposes, one of which is to be included in publicly released financial statements. Under U.S. GAAP, Morgan Stanley has $832.7 billion of assets, and so Morgan Stanley tells you that that’s how many assets it has.

Another form of measurement is the thing used to calculate the leverage ratio. This manages to find rather more assets at Morgan Stanley. Where does it find them? Oh, places. Generally, the new rule counts “total leverage exposure” to include:

• GAAP assets;
• potential future exposures for derivatives;
• other adjustments for derivatives to back out some cash collateral netting;
• lending commitments;
• sold credit protection;
• “repo-style” transactions;
• “all other off-balance sheet exposures”; and
• probably some other things too?

So you just dump all those things on the table, without risk-weighting them, and … wait no hang on that’s not true either. The claim that assets are not risk-weighted for the leverage ratio turns out to be totally untrue. GAAP assets are, for these purposes, assigned a risk weighting of 100 percent, whether they’re Treasuries or junk bonds. But everything else gets its own specialized weight. Lending commitments are risk-weighted at 10 percent of the amount of the commitment. Derivatives are weighted at 100 percent of notional, for sold credit derivatives,4 or 10 percent, for bought high-yield credit derivatives or 5+ year equity derivatives, or 8 percent, for 1-5 year equity derivatives or 5+ year precious metal derivatives (except gold, which is risk-weighted at 7.5 percent), or 6 percent, for 1-year-or-less equity derivatives, or 5 percent, for bought investment-grade credit derivatives or 1-5 year foreign exchange derivatives, or 1.5 percent, for 5+ year interest rate derivatives, or … you get the idea. Or do you? Is there an idea?

Risk Magazine, which was correctly worried that these tougher rules were likely to be implemented, flagged what businesses would be most affected:

Banks have since downplayed the impact during earnings calls, but the tougher ratio will deal a heavy blow to certain businesses – custody, repo and derivatives trading, for example.

What can banks do about it? Well, when it comes to derivatives, one option is to clean house. Swap portfolios invariably comprise layer upon layer of partially offsetting trades that amount to a relatively small net risk position, but it’s the gross number that matters from the point of view of the leverage ratio. So, tearing up unnecessary positions can be a big help, and many dealers have thrown a lot of energy into this compression process over the past year. But as well as being a science, this is also an art – and one that smaller institutions admit they have not yet mastered.

US regulators had from time to time said they wanted to make it more costly and difficult to be too big to fail; this is one way to go about it. The New York Times reports that regulators estimate that the banks subject to this rule will have to raise as much as $68 billion in capital by 2018. They can do that by selling new equity, shedding operations by selling them, shrinking their balance sheets, or retaining more earnings. The most logical route, if banking weren’t an exercise in looting, would be to retain more earnings, which means lowering pay levels. But that may wind up happening regardless as formerly attractive-looking business become less so under the new rules.

John Cassidy at the New Yorker discussed how this new rule was implemented despite the usual vigorous financial lobbyist campaign against it, but that this could augur in more restrictions on banks’ freewheeling ways:

The new requirements certainly don’t rule out the possibility of another banking crisis, and they don’t solve the too-big-to-fail model. But they make the former less likely, and they go some way toward addressing the negative externality that lies at the heart of the latter. Another promising thing about them is that they can be further developed. Once you accept the logic of beefing up capital requirements, there is nothing sacred, or particularly persuasive, about stopping at five per cent…

In her statement, Yellen talked about extending the new rule to international banks that are active in the United States, a possibility that would be allowed under the latest version of Basel III. Daniel Tarullo, a Fed governor who has been one of the strongest proponents of using capital requirements as a regulatory tool, reiterated his call for a surcharge on “risk-based” capital, which could discourage the big banks from relying on short-term funding that tends to dry up in a crisis. These are both eminently reasonable ideas, and a few years ago I would have said that they had little chance of being enacted. But the new rule shows that some progress is indeed possible.

While one robin does not make a spring, this is an important, and unambiguously positive development. Giving the authorities credit for moving in the right direction will encourage them to do more of the same.

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