Monday, February 21, 2011

Higher Capital Ratios Do Not Guarantee Lower Risk In Banking System

Bloomberg reported that Paul Tucker, the Deputy Governor of the Bank of England, and Adair Turner, the Chairman of the Financial Services Authority, are hoping that new regulations requiring banks to hold higher capital ratios will reduce both risk in the banking system and executive pay.

By themselves, higher capital ratios do not guarantee a reduction in risk in the banking system or a reduction in executive pay.

In fact, higher capital ratios will most likely lead to the preverse outcome of actually increasing the amount of risk in the banking system.  Compensation driven by either gross net income or return on equity directly drives the bank executive's choice of both assets to put on the balance sheet and how to fund them.

For example, in the US, in the mid-1980s, a large regional bank suffered hundreds of millions in losses because bank executives had a sizable amount of their compensation tied to return on equity.  Prior to the loss, the bank had the highest capital ratio of any major bank in the world.  This high level of capital necessitated the bank purchasing $3 billion of 30 year Treasuries in order to generate the interest income needed to achieve the return on equity target.  Naturally, interest rates moved up and the bank lost roughly half its capital.

What does guarantee a reduction of risk in the banking system, both traditional and shadow, is fully implementing the FDR Framework by requiring the disclosure of all useful, relevant information in an appropriate, timely manner to all market participants.

This information can be used by credit and equity market analysts, as well as competitors, to analyze the risk of a financial institution and price investments in the financial institution.  If a financial institution takes on more risk, it can be expected that its cost of funds will increase to reflect this risk.  [emphasis added]
Bank of England Deputy Governor Paul Tucker said ... that lower returns on equity for banks would give shareholders a greater incentive to cap executive payCredit Suisse Group AG cut its profitability goal this month after concluding stricter capital rules will constrain earnings. The Zurich-based bank will aim for a return on equity of more than 15 percent over three to five years, down from a previous target of more than 18 percent. 
“By reducing their return on equity, I think myself that that will eventually have an impact on compensation too,” Tucker said. “As that return on equity comes down, I think they will start to put pressure on the returns that go to managers.” 
Tucker said that policy makers had made some progress in the area of financial reform.
“Basel III is cooked,” he said. “We got many other countries to agree to a higher capital ratio than they wanted to agree to.” 
Financial Services Authority Chairman Adair Turner, speaking at the same event, said that if regulators were “benevolent dictators” working in an “ideal world,” bank capital ratios would be as high as 20 percent. 
The Basel Committee on Banking Supervision said last year it will require lenders to have common equity equal to at least 7 percent of assets weighted according to riskiness, an increase from the current 2 percent standard, including a 2.5 percent buffer to withstand future shocks. 
“When you’ve ended up with too high a leverage, if you try and move out of that too quickly you will slow down the real economy,” Turner said.

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