Tag Archives: Basel

Missing the Point

By James Kwak

The Basel Committee’s recent decision to change the definition of the leverage ratio is bad news for two reasons.

There’s the obvious: A smaller denominator means less capital. The leverage ratio requirement says, in principle, that banks must have capital equal to at least X% of their total unweighted assets, where “assets” is supposed to include anything they hold that could fall in value. Take some bank that has some amount Y of traditional assets and other things that could fall in value, like derivatives positions. Then it has to have capital equal to X * Y / 100. If we take the exact same bank but decide to call Y some smaller number, say Z, then it can get bay with less capital. Less capital = more risk.

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Required Intellectual Capital

By Simon Johnson

At one level, the pursuit of higher and more robust capital requirements for banks is not going well.  The US Treasury insisted, throughout the year-long financial reform debate, that capital should be the focus – increasing the loss-absorbing buffers that banks must carry – and that they (and other regulators) needed to negotiate this is through the Basel Committee process.

But Basel has some under great pressure from the banking lobby, which argues that any increase in capital requirements would limit lending and slow global growth (see this useful background by Doug Elliott).  The Institute of International Finance (IIF) – a lobby group for big banks – issued an influential “report” along these lines and the European stress test results strongly suggest that Euroland politicians do not want to press more capital into their financial system – “just enough” would be fine with them.

However, at another level – in terms of the analytical consensus around these issues – there is a great deal of progress in the right direction.  In particular, an important new paper by Samuel Hanson, Anil Kashyap, and Jeremy Stein, “A Macroprudential Approach to Financial Regulation” pulls together the best recent thinking and makes three essential points.  (This is a nontechnical paper written for the Journal of Economic Perspectives – it’s a “must read” for anyone interested in financial sector issues but requires some effort and a little jargon does creep in.) Continue reading

State Banking, Globally

 By Simon Johnson

A standard refrain from U.S. banking industry lobbyists is “you cannot put us at a disadvantage relative to our overseas competitors.”  The Obama administration has largely bought into this line and cites it in public and private as one reason for opposing size caps on our largest banks and preventing Congress from raising capital requirements.

The US Treasury puts its faith instead in the Basel Committee on Banking Supervision process, a somewhat murky convocation of bank regulators from various countries that has a weak track record in terms of setting sufficient prudential standards (also the assessment of Dan Tarullo, now an influential Federal Reserve governor; disclosure, I have a part-time position at the Peterson Institute, which published his book).  But, the official US reasoning goes, the crisis of 2007-08 was so traumatic, our European counterparts will now want to be more careful. Continue reading

Capital Requirements Are Not Enough

By Simon Johnson and James Kwak, authors of 13 Bankers: The Wall Street Takeover and the Next Financial Meltdown (Pantheon, 2010).

The number of important people expressing serious concern about financial institutions that are too big or too complex to fail continues to increase. Since last fall, many leading central bankers including Mervyn King, Paul Volcker, Richard Fisher, and Thomas Hoenig have come out in favor of either breaking up large banks or constraining their activities in ways that reduce taxpayers’ exposure to potential failures. Senators Bernie Sanders and Ted Kaufman have also called for cutting large banks down to a size where they no longer pose a systemic threat to the financial system and the economy.

To its credit, the Obama administration recognizes the problem; according to Treasury Department officials, addressing “too big to fail” is one of the central pillars of financial reform, along with derivatives and consumer protection. However, the administration is placing its faith in technical regulatory fixes. And, as Andrew Ross Sorkin emphasizes in his recent Dealbook column, they see increased capital requirements as the principal weapon in their arsenal: “[Treasury Secretary Tim] Geithner insists that if there is one change that needs to be made to the banking system to protect it against another high-stakes bank run like the one that claimed the life of Lehman Brothers, increasing capital requirements is it.”

(Brief primer: Capital is money contributed by a bank’s owners–conceptually, their initial capital contributions plus reinvested profits–that does not have to be paid back. Therefore, it acts as a buffer to protect a financial institution from defaulting on its obligations as the value of its assets falls. The more capital, the less likely a bank is to fail. The more capital, however, the lower the institution’s leverage, and hence the lower its profits per dollar of capital invested–which is why banks always want lower capital requirements.)

Don’t get us wrong: we think that increased capital requirements are an important and valuable step toward ensuring a safer financial system. We just don’t think they are enough. Nor are they the central issue. Continue reading