Tougher capital standard vigilantes keep forgetting that bank book capital is currently meaningless

Of all the global financial reforms adopted since the beginning of the bank solvency led financial crisis, the single most damaging has been the adoption of higher bank capital standards.

Adopting higher bank capital standards has directly led to

• Bailouts of the banks by their host countries.  At a minimum, this has diverted scarce resources that could have been used to stimulate economic growth.  At the other extreme, it has managed to bankrupt at least one country (see Ireland). 

• Suspension of mark-to-market accounting.  This suspension disconnected capital as shown in the financial statements from any relationship with the true market value of the bank's assets.

• Regulatory forbearance.  This supports ongoing funding of zombie loans.

The combination of suspension of mark-to-market accounting and regulatory forbearance led the OECD to declare bank book capital meaningless.

Adopting higher capital standards has also directly led to

• A credit crunch in Europe as the banks adjust their balance sheets so as to achieve a 9% Tier I capital ratio by June 30, 2012.

• Privatizing gains and socializing losses.  By design since the 1930s, banks can act as a circuit breaker and prevent the losses on financial excess from damaging the real economy.  Banks can only do this if their book capital level is allowed to decline as far as necessary to absorb the losses.  The focus on capital levels has prevented and is preventing the banks from protecting the real economy.

A Reuters article describes the latest effort by the tougher capital standard vigilantes.

Former Federal Deposit Insurance Corp Chairman Sheila Bair is leading an effort to convince the Federal Reserve to get tougher on the largest U.S. banks. 

Bair and three academics are urging the Fed to impose more stringent capital standards on financial giants and criticizing the U.S. central bank's recent decision to allow big banks, such as JPMorgan Chase, to boost stock dividends rather than use these funds to fortify their balance sheets.

Until such time as all the losses hidden on and off JP Morgan's balance sheet have been recognized, it is premature to talk about fortifying its balance sheet.

"We feel compelled to express our grave concerns about the premature capital distributions which the (Fed) approved as a result of stress tests it completed this year and in 2011," they wrote in a March 30 letter to the Fed. "Dividends and buybacks inevitably slow the pace at which these large banks build their capital buffers."...

Under the Japanese model for handling a bank solvency led financial crisis, losses are only recognized to the extent that the bank generates earnings in excess of banker bonuses, dividend payments and modest book capital level increases.

Reducing dividend payments and buybacks to zero does nothing to speed up the process of loss recognition.

The letter from Bair and the academics was sent in response to a set of proposals that the Fed released in December. 

Those proposals laid out new standards that bank holding companies with more than $50 billion in assets and other large financial firms will have to meet under the 2010 Dodd-Frank financial oversight law, which was enacted in response to the 2007-2009 financial crisis....

Bair and her colleagues are urging the Fed to use this set of rules to ratchet up future capital requirements, or how much a bank has to fund itself through equity as opposed to debt, to reduce risk to the financial system. 

They argue that the Fed proposal relies too much on the judgment of regulators for keeping an eye on banks and should instead focus on clear rules. 

"The strength of supervisory resolve ebbs and flows, in accordance with political will and agency leadership," the letter reads. "In contrast, simple, straightforward rules... remain constant regardless of whether regulation is in or out of fashion."

Please re-read the highlighted text again as it is the reason that banks must be required to provide ultra transparency and disclose on an on-going basis their current asset, liability and off-balance sheet exposure details.

Bank capital requirements are defined by regulation and therefore are subject to ebbs and flows.

Ultra transparency is not subject to ebbs and flows as it covers every exposure detail.

They said the Fed proposal also ignores a lesson of the financial crisis that when trouble comes, markets only trust firms that have a lot of common equity as opposed to other forms of funding that can be used to meet capital requirements.

Actually, the banks themselves showed that this was not a lesson of the financial crisis.  The authors conveniently leave out the fact that the interbank lending markets froze.

The interbank lending market froze because no bank could figure out if any other bank was solvent or not (the conclusion of the Financial Crisis Inquiry Commission report).

The only way for banks to be able to determine if the market value of another bank's on and off-balance sheet assets exceeds the book value of its liabilities is if the banks are required to provide ultra transparency and disclose their exposure details.

The bottom line is that bank book capital is a meaningless accounting construct so it is not surprising that focusing on bank book capital leads directly to bad outcomes for the real economy.