Restoring trust in bank capital

The Lex column of the Financial Times reviewed the bank capital debate between simple leverage ratios and complex, easily manipulated risk weighted asset ratios and concluded that something must be done to restore trust in bank capital.

Regular readers know that the foundation of trust in the financial system is disclosure.  Disclosure is the foundation because without it market participants cannot Trust, but Verify.

For banks, the required level of disclosure is ultra transparency.  Under ultra transparency, banks disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.

With these details, market participants can assess the risk and value of each bank's exposures.

With this assessment, market participants can adjust a bank's book capital level for the difference between the market value of its exposures and the book value of its exposures.  The result is a realistic estimate of a bank's current capital position.

Market participants can then use this realistic estimate of a bank's current capital position if they want to look at simple leverage ratios or a risk-adjusted capital ratio and compare it to what the banks are reporting.  Trust in bank capital and its related ratios is restored when what the banks report matches up to the market participants independent assessment.