Eurozone banks show how easily manipulated and therefore how meaningless bank capital is [updated]

In what should be required reading for every policymaker, financial regulator and economist/finance professor who thinks that bank capital is important, Bloomberg published an article describing how Eurozone banks are using financial alchemy to manipulate their capital ratios.

Bank capital is like Dracula.  I keep sticking a stake through its heart, but it keeps coming back.

I tried by using the example of a parent answering their child's question of how can they know they are going to be able to get their money back when they put it into a bank account.  No parent whips out the bank's financial statement, points to the lower right hand corner and says "so long as this is greater than zero, the bank will give you your money back."  All parents say "the government guarantees that you will get your money back."

But still the Dracula that is bank capital comes back.

I tried by using the definition of bank solvency.  A definition which does not include bank capital.  Solvency, as defined by the Financial Crisis Inquiry Commission, is the difference between the market value of the bank's assets and the book value of its liabilities.  If the difference is greater than zero, the bank is solvent.  If the difference is less than zero, the bank is insolvent.

But still the Dracula that is bank capital comes back.

I tried by referring to Walter Bagehot, the author of Lombard Street, the 1873 classic that is the playbook for central banks.  He observed that "a well-run bank needs no capital.  No amount of capital will save a badly run bank."

But still the Dracula that is bank capital comes back.

Fortunately, while I could not kill the Dracula that is bank capital, the Eurozone bankers could.

Banks in Europe are undercutting regulators’ demands that they boost capital by declaring assets they hold less risky today than they were yesterday. 

Banco Santander SA (SAN), Spain’s largest lender, and Banco Bilbao Vizcaya Argentaria SA (BBVA), the second-biggest, say they can go halfway to adding 13.6 billion euros ($18.8 billion) of capital by changing how they calculate risk-weightings, the probability of default lenders assign to loans, mortgages and derivatives. 

The practice, known as “risk-weighted asset optimization,” allows banks to boost capital ratios without cutting lending, selling assets or tapping shareholders. 

Regulators in Europe, seeking to stem the region’s sovereign-debt crisis, ordered banks last month to increase core capital to 9 percent of risk-weighted assets by the end of June. 

Lenders, facing a 106 billion-euro shortfall, are reluctant to plug the gap by cutting dividends or bonuses and are struggling to sell assets or raise cash in rights offerings. 

Politicians are trying to stop banks from the alternative, cutting back lending, because it could trigger a recession. 

“By allowing sophisticated banks to do their own modeling, we are allowing the poacher to participate in being the game- keeper,” said Adrian Blundell-Wignall, deputy director of the Organization for Economic Cooperation and Development’s financial and enterprise affairs division in Paris. “That risks making core capital ratios useless.” 

Spanish banks aren’t alone in using the practice. Unione di Banche Italiane SCPA (UBI), Italy’s fourth-biggest bank, said it will change its risk-weighting model instead of turning to investors for the 1.5 billion euros regulators say it needs. Commerzbank AG (CBK), Germany’s second-biggest lender, said it will do the same. Lloyds Banking Group Plc (LLOY), Britain’s biggest mortgage lender, and HSBC Holdings Plc (HSBA), Europe’s largest bank, both said they cut risk-weighted assets by changing the model. 

“It’s probably not the highest-quality way to move to the 9 percent ratio,” said Neil Smith, a bank analyst at West LB in Dusseldorf, Germany. “Maybe a more convincing way would be to use the same models and reduce the risk of your assets.” 

European firms, governed by Basel II rules, use their own models to decide how much capital to hold based on an assessment of how likely assets are to default and the riskiness of counterparties. The riskier the asset, the heavier weighting it is assigned and the more capital a bank is required to allocate. The weighting affects the profitability of trading and investing in those assets for the bank.

While firms submit their models to national regulators once a year, they don’t have to disclose them publicly, and risk- weightings for the same assets vary among banks, regulators and analysts say. 

“There are potentially significant differences in how different banks calculate RWA,” Daragh Quinn, an analyst at Nomura Holdings Inc. in London, said in a telephone interview. “It’s a very gray area.”... 

Under Basel III, which maintains the same risk-weighting methodology as Basel II, all lenders will be required to use their own models to assess the riskiness of assets and therefore how much capital they need to hold. 

“As you move to Basel III, these issues will become more ubiquitous, not less,” the OECD’s Blundell-Wignall said. “The core Tier 1 ratio is a ratio of two meaningless numbers, which itself is a meaningless number because banks can alter the ratio themselves. Basel III does absolutely nothing to address that.” 

Please re-read this quote as the comment about the Tier 1 capital ratio is the stake through the heart of the bank capital Dracula.

Sheila Bair, who stepped down as chairman of the Federal Deposit Insurance Corp. in June, has called Europe’s adoption of risk-weighting “naive.”...

“It is in a bank manager’s interest to say his assets have low risk, because it enables the bank to maximize leverage and return on equity, which in turn can lead to bigger pay and bonuses,” Bair wrote in Fortune magazine on Nov. 2. “Indeed, even during the Great Recession, as delinquencies and defaults increased, most European banks were saying their assets were becoming safer.”... 

Investors are unlikely be satisfied by banks adjusting risk models to avoid raising capital, said Harrison, the Barclays analyst, who is based in London. 

“Gaming RWAs isn’t helpful, particularly if the objective is to convince the market to invest in banks again,” Harrison said. “The risk is that it’s counterproductive, because there is even less faith in what the banks are telling you.”

This is the reason that your humble blogger has been pushing for banks to disclose their current asset, liability and off-balance sheet exposure detail.  With this data, market participants don't have to rely on what the banks or regulators are telling them, but instead can independently assess the risk of each individual bank and make comparisons across banks.

Update


Right after the Eurozone banks drove a stake through the heart of the bank capital Dracula, there is the Federal Reserve trying to revive bank capital.

Fed Governor Daniel Tarullo was quoted in a Bloomberg article as saying

regulation of banks’ capital “remains the single most important element of prudential financial regulation” without being “sufficient” on its own to ensure a sound financial system.

Putting Governor Tarullo's statement together with the comments on bank capital made by the OECD's Bludell-Wignall and Barclays analyst Harrison we get

regulation of banks' capital a meaningless, easily gamed number remains the single most important element of prudential financial regulation.  

That pretty much sums up why market participants still do not have any confidence in the financial system.

So that we can put an end to the financial crisis, could we please have the global financial regulators require that each bank disclose its current asset, liability and off-balance sheet exposure detail.  That way, market participants can figure out who is solvent and who is insolvent and adjust both the amount and price of their exposure accordingly.