Sunday, December 4, 2011

Can today's meaningless, easily manipulated bank capital ratios be saved?

With its Financial Stability Report, the Bank of England followed in the footsteps of the Organization for Economic Co-operation and Development (OECD) and showed why today's bank capital ratios are highly manipulated and meaningless.

First, there is the problem with book capital, the numerator in a bank capital ratio.  The amount of reported bank capital is distorted by regulatory forbearance and suspension of mark to market accounting.

In both the Financial Stability Report and a Guardian article, the UK's FSA estimates that bank book capital is overstated by 5 billion pounds based on extend and pretend policies applied to 50 billion pounds of commercial real estate exposures.  This is before we get to similar policies on mortgage loans to individuals.

Suspension of mark to market on sovereign debt and structured finance securities further distorts reported bank book capital.

The bottom line is that today regulatory policy easily manipulates bank book capital and deprives it of any meaning.

Second, there is the problem with how banks calculate their risk-weighted assets, the denominator in the bank capital ratio.  Banks calculated the risk-weights on their assets differently.  The Financial Stability Report suggests that it would not be unusual for a large bank to use over 100 models in calculating its total risk adjusted assets.

In fact, as this blog has previously documented, banks "optimize" their risk-weights to minimize their risk adjusted assets in order to produce the highest capital ratios.

The bottom line is that today banks easily manipulate risk adjusted assets and deprive it of any meaning.

The question is how to restore meaning to bank capital ratios and end the various ways that they can be manipulated?

Regular readers know that the solution is implementing ultra transparency.  By requiring banks to disclose on an on-going basis their current asset, liability and off-balance sheet exposure details, meaning is restored to bank capital ratios.

Ultra transparency directly addresses over-stating bank capital.  Market participants will use the disclosed data to calculate the current market value of the bank's exposures.  They will use the difference between current market value of the bank's exposures and the book value of these exposures to adjust bank book equity.

This adjusted bank book equity is a meaningful number to use in calculating a bank's capital ratio.

Ultra transparency directly addresses under-stating risk adjusted assets.  Market participants will use the disclosed data to independently calculate risk adjusted assets.  Thereby rendering meaningless the bank's efforts to game the risk adjusted asset calculation.

The independently calculated risk adjusted assets is a meaningful number to use in calculating a bank's capital ratio.

Ultra transparency brings meaning back to both the numerator and denominator of the bank's capital ratio and thereby restores meaning to a bank's capital ratio.

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