To meet capital requirements, banks don't shed risk

Your humble blogger has frequently criticized the financial regulators for their timing in imposing higher capital requirements.  The timing simply does not make sense in the absence of the requirement that banks disclose on an on-going basis their current asset, liability and off-balance sheet exposure details.

Without this data, there is no way for market participants to assess the risk of each bank or each of the bank's exposures.

For example, since the beginning of the financial crisis, regulators have been practicing forbearance.  This distorts the reported value of the loan portfolio as well as the reported book equity turning capital ratios into meaningless junk.

Instead, regulators should require ultra transparency.  After banks have implemented ultra transparency, market discipline will cause them to mark all their exposures to realistic values.  It is this activity by the banks that is necessary to turn the meaningless capital ratios into something meaningful and end the buyers' strike in bank equity, particularly European bank equity.

By enforcing higher capital ratios now, we have banks playing games with their risk adjusted assets including reducing loan availability; otherwise known as a regulator induced credit crunch.

A Financial Times article shed light into the size of the problem caused by prematurely enforcing a meaningless higher capital ratio.

European banks will have to raise nearly €200bn ($260bn) in new capital or cut their balance sheets by nearly 20 per cent, to achieve the tougher new Basel III banking reform rules that start taking effect in 2013, a new study has found. 

The study by the Boston Consulting Group looked at the efforts of 145 large banks worldwide to comply with that ratio and found they need to raise €354bn in capital on top of what they had at the end of 2010 or cut their risk-weighted assets by €5tn or 17 per cent. 

Banks in Europe had significantly further to go than those in the US and Asia, which each faced a collective shortfall of slightly less than €70bn. 

The global Basel III package aims to make banks more resilient by forcing them to hold more, better quality capital against unexpected losses. The rules, which are set globally, require banks to hold core tier one capital equal to 7 per cent of their assets adjusted for risk or face restrictions on paying bonuses and dividends. 

The study measured the European shortfall at €221bn, but roughly 20 per cent of that will be covered by the end of this year, the authors said. They estimated that European banks have already cut risk weighted assets by 5 per cent.... 

“Banks want to stay ahead of regulatory timetables as a demonstration to investors that they are financially strong,” said Ranu Dayal, the BCG senior partner who led the work. 

EU banks face an additional push from this month’s European Banking Authority stress tests which required them to achieve a 9 per cent ratio by 2012 using a somewhat looser definition of capital. The BCG study said the EBA rules effectively compress the time frame for meeting the Basel III requirements. 

Quick action could do much to strengthen the shaky European financial system but, collectively, the banks’ plans could pose a threat to the broader economy if they chose to cut lending rather than raise capital. 

BCG notes that some banks may also seek to cut their RWAs by tinkering with the models they use to measure risk, a process known as “optimisation”, and that the industry is lobbying hard to water down the Basel III proposals that sharply limit what can be counted as core tier one capital. 

Many bank chiefs are reluctant to raise additional equity because share prices are relatively low. 

Which reflects the fact that without ultra transparency so they can assess the risk of an individual bank, investors are essentially on a buyers' strike.