WSJ doubts bank capital is a panacea

A Wall Street Journal Heard on the Street column expressed doubts about bank capital as a solution.

Higher levels of capital aren't a panacea for banks. 

That is a lesson from this week's release of the Federal Deposit Insurance Corp.'s quarterly banking profile. The FDIC noted that 96% of the nation's banks "met or exceeded the highest regulatory capital requirements." 

In other words, only 303 institutions—the other 4%—failed to meet the highest capital requirements. But the FDIC also reported that the number of institutions on its "Problem List" increased by four during the quarter to 888. Banks placed on the problem list are in greater danger of failing. 

This means that there are 585 problem institutions that ostensibly have more than enough regulatory capital, a measure of loss-absorbing equity adjusted for a variety of factors. How can this be? The FDIC looks at more than just capital levels when deciding whether an institution is at risk. This illustrates why investors should use measures of regulatory capital only as a starting point in assessing bank strength. 

This paragraph highlights everything that is wrong with the financial regulators having a monopoly on all the useful, relevant current information on banks and why the focus on regulatory capital is misguided.

The starting point for an investor determining if a bank is solvent is to look at the current value of its assets and the book value of its liabilities.  A bank is solvent if the current value of its assets exceeds the book value of its liabilities.  It is insolvent if the current value of the assets is less than the book value of its liabilities.

This starting point is also the same starting point that investors use for exerting market discipline on banks.  If the risk of a bank's assets increases, investors adjust both the amount and pricing of their exposure to the bank.  This is market discipline.

However, because of the regulatory monopoly on current asset level data, investors cannot analyze the solvency of a bank or exert market discipline.  Instead, they have to rely on the financial regulators to do this.

Unfortunately, financial regulators do not do this.  For example, look at the 585 problem institutions referenced above.  Instead of closing these institutions, the financial regulators have adopted the policy of gambling on redemption.  This involves hiding the fact that the banks are highly likely to be insolvent and hoping that something will occur that will restore the banks to solvency. 

A paper last week by Thomas Hoenig, president of the Federal Reserve Bank of Kansas City, and Charles Morris, a Fed economist, also pointed out the danger of overreliance on capital levels. The two argued that new, tougher, international standards governing capital rules for banks won't be enough to curtail the risk posed by too-big-to-fail banks. 

Messrs. Hoenig and Morris cited "the complexity of the largest financial companies and the variety of their activities." Their solution? Break up big banks by splitting one group of businesses—lending, asset management and underwriting and advisory work—from activities such as brokerage and market-making activity as well as trading for their own accounts. 

That is a radical Rx. Then again, it would acknowledge that even the best-crafted capital requirements aren't always enough to make sure banking boats won't capsize in a market storm.

Your humble blogger has been advocating a far less radical Rx that has passed the test of time.  The solution is to make each bank's current asset and liability-level data available to all market participants.

With this data, market participants can evaluate the risk of each bank and adjust the pricing and amount of their exposure relative to this risk.  This brings market discipline to bear on banks as investors understand that they are at risk of loss of their investment if a bank were to become insolvent.

With the disclosure of the current asset and liability-level data, it also ends the era of financial regulators gambling on redemption and forcing investors to guess which banks the regulators are gambling on.  For example, are the regulators gambling on the Too Big to Fail banks today?