Sheila Bair: capital ratios let regulators make banks look safer than they are

In her Wall Street Journal column, former FDIC chairwoman Sheila Bair drives a stake through the heart of bank capital, the Basel capital requirements in particular, by observing that capital ratios let regulators make banks appear safer than they actually are.

Ms. Bair's conclusion is exactly what your humble blogger has been saying since the beginning of the financial crisis.

Bank capital ratios suffer from two fundamental flaws:

• They are easily manipulated by banks, regulators and policy makers.  Banks manipulate the ratios by gaming the calculation of risk adjusted assets.  Regulators manipulate the ratios by practicing regulatory forbearance and letting banks engage in 'extend and pretend' to turn their non-performing loans into 'zombie' loans.  Policy makers manipulate the ratios by insisting on the suspension of mark-to-market accounting for securities.

• They are designed to hide the true condition of the banks.  Having been involved in the development of Basel I, I can tell you the basic idea behind Basel I was to hide the amount of leverage that banks were taking on so they could generate a high return on equity.  Regulators bought into the idea that banks needed a higher return on equity to attract capital.

There is only one way to assess the risk of a bank.  That is to look at a bank's current global exposure details.

This is why your humble blogger has been saying that banks need to provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.

With this information, market participants can assess the true condition of the bank.

With this information, market participants can, if they want, calculate a capital ratio that is not subject to measurement errors introduced by banks, regulators or policy makers.

The recent Senate report on the J.P. Morgan Chase JPM +0.77% "London Whale" trading debacle revealed emails, telephone conversations and other evidence of how Chase managers manipulated their internal risk models to boost the bank's regulatory capital ratios. 

Risk models are common and certainly not illegal. Nevertheless, their use in bolstering a bank's capital ratios can give the public a false sense of security about the stability of the nation's largest financial institutions. 

At a minimum, risk models introduce measurement error and the ability for banks to manipulate their appearance of safety and soundness.

Capital ratios (also called capital adequacy ratios) reflect the percentage of a bank's assets that are funded with equity and are a key barometer of the institution's financial strength—they measure the bank's ability to absorb losses and still remain solvent.

Capital ratios are nice in theory, but don't work in practice for two reasons.

First, capital ratios are easily manipulated, they are not an accurate measure of a bank's ability to absorb losses and remain solvent over the long term.

Second, banks are uniquely designed so they can continue to operate even when they are insolvent for a period of time.

This is a very important point as it highlights the simple fact that only in the world of bank regulators and academic economists are capital ratios important.

As I highlighted in my hierarchy for dealing with insolvent banks (where the market value of the bank's assets is less than the book value of its liabilities), the first place to absorb losses and the primary source of a bank's financial strength is the bank's ability to generate earnings before banker bonuses in the future.  It is a bank's ability to generate earnings in the future that allows it to rebuild in book capital levels.

This should be a simple measure, but it isn't. That's because regulators allow banks to use a process called "risk weighting," which allows them to raise their capital ratios by characterizing the assets they hold as "low risk."...

As we learned during the 2008 financial crisis, financial models can be unreliable. Their assumptions about the risk of steep declines in housing prices were fatally flawed, causing catastrophic drops in the value of mortgage-backed securities. 

And now the London Whale episode has shown how capital regulations create incentives for even legitimate models to be manipulated....

The ease with which models can be manipulated results in wildly divergent risk-weightings among banks with similar portfolios. 

Ironically, the government permits a bank to use its own internal models to help determine the riskiness of assets, such as securities and derivatives, which are held for trading—but not to determine the riskiness of good old-fashioned loans. 

The risk weights of loans are determined by regulation and generally subject to tougher capital treatment. As a result, financial institutions with large trading books can have less capital and still report higher capital ratios than traditional banks whose portfolios consist primarily of loans.

Regulators need to use a simple, effective ratio as the main determinant of a bank's capital strength and go back to the drawing board on risk-weighting assets. 

It does make sense to look at the riskiness of banks' assets in determining the adequacy of its capital. 

But the current rules are upside down, providing more generous treatment of derivatives trading than fully collateralized small-business lending.

Your humble blogger has been saying since the beginning of the financial crisis that the only way to determine the riskiness of a bank is by looking at its assets.  Here is Ms. Bair confirming that point.

All of this makes the case for requiring banks to provide ultra transparency and disclose their current exposure details as it takes away the ability of either banks or regulators to distort the true safety of the banks.

It is intuitively ridiculous to have capital requirements that assign a lower risk weighting to derivatives that fully collateralized loans.

The main argument megabanks advance against a tough capital ratio is that it would force them to raise more capital and hurt the economic recovery....

That is the beauty of requiring the banks to provide ultra transparency.  It doesn't force the banks to raise more capital.  It gives them the alternative to shrink by eliminating proprietary bets and subsidiaries that exist solely to engage in regulatory or tax arbitrage.