Coppola Comment

Musings from an amateur economist and one-time professional banker


A really scary story

There was a scary headline in the FT yesterday:
And the report went on to explain:

"The 19 largest US banks are at least $50bn short of meeting new capital requirements under the Basel III accords, according to rules proposed by the Federal Reserve.
The biggest among them would probably need billions of dollars more by the 2019 deadline to comply fully with the rules. Smaller US lenders are about $10bn short of the requirements, the Fed said on Thursday."

Terrifying. And complete rubbish.
These are capital requirements that don’t come into force until 2019. The third paragraph of the report says:

"….most banks should be able to reach the new levels by retaining earnings during the next few years rather than by raising capital in the market".

So NORMAL activity will be enough for most banks to meet the new requirements. No shortfall, then. Nothing to look at here. Move along, now.
But in trying to make a scary story out of nothing at all, the writer of this article has completely missed the real issues. There really is a scary story here, but it isn’t the risk that banks won’t meet the new capital requirements.  That’s a red herring.
The real issues are further down the article. Here’s scary issue number 1:

"Some banks will be able to calculate their needed levels of capital using internal models, subject to Fed approval"

If you want scary, this should do it nicely. The risk weightings of the complex instruments that failed in the 2008 financial crisis were calculated using banks’ own internal models. Using a UK example, both RBS and HBOS were given permission by the FSA to use their own models to calculate risk weightings, and it is fair to say that the FSA hadn’t a clue how these models worked. What we do know – now – is that the models allowed the banks to assign far lower risk weightings to the instruments than their actual risk turned out to be. Capital requirements rely on calculation of risk weights – the higher the risk weight, the more capital required to support the asset. So instruments that were actually highly risky were assigned low risk weights by banks using their own models, which allowed banks to reduce their capital – in some cases to dangerously low levels – and the regulators were so impressed with these models that they didn’t bother to investigate whether the results they churned out accurately reflected the risk of the assets.
You’d think we would have learned by now that there is IMMENSE moral hazard in allowing banks to use their own models to value and risk weight assets for capital allocation purposes. So why on earth are Fed allowing banks to continue to do this? And the usual defence of this practice – "only the banks really understand these instruments so it’s appropriate to use their models" – simply won’t wash any more. Regulators MUST understand these instruments, so that they can verify the valuations and risk weightings assigned to them. If the instruments are so complex and so poorly documented that regulators can’t understand them, THEY SHOULD NOT BE TRADED.
And here’s scary issue number 2.

"Banks will have to hold the same amount of capital against their holdings of sovereign debt issued by Germany as they would for Portugal, Spain and Ireland"

What is happening is that banks are being prevented from using credit rating agencies to provide a measure of risk. If this led to banks doing their own due diligence on investments that would be a good idea.  But that’s not what the article is saying. It is actually suggesting that the credit ratings agencies’ ratings should be replaced with….nothing. No assessment of default risk at all.  Now, it is not in a bank’s interests to tie up capital on investments that are low-risk and therefore give a poor return. If the bank has to allocate the same amount of capital against German debt as it does for Portuguese, but the Portuguese debt pays higher interest, which one will it buy? We have played this scene before. This is how the weaker sovereigns in Euroland got themselves into so much trouble – banks bought their debt in preference to stronger ones because it carried the same risk weighting but paid them a bit more. If the reporter has got this right, it suggests that the Fed (and maybe even the Basel Committee) have learned nothing from the sovereign debt crisis, just as issue no. 1 suggests that they have learned little from the 2008 investment banking collapse.
And finally – scary issue number 3. For this we have to return to the start of the article.

"….most banks should be able to reach the new levels by retaining earnings during the next few years rather than by raising capital in the market".

Now, I know I said this wasn’t scary. But it is – just not in the way that the article suggests. You see, if banks are retaining earnings in order to shore up their capital buffers to meet higher regulatory requirements, they WON’T LEND – especially not to riskier prospects. Lending requires capital: every loan on the banks’ balance sheets ties up a certain amount of capital, and the riskier the loan the more capital it ties up. In America prior to 2008, banks freed up capital by selling loans for securitisation. But the mortgage-backed securities market is moribund and other securities markets are much smaller. So banks are already having to keep more on their balance sheets than they did before, which ties up capital and restricts lending. If they have to retain earnings to build up their capital, they will lend even less. The US should beware. Raising capital requirements when the securities markets are not functioning properly and shareholders’ returns are down is asking for a credit crunch. Banks have seven years to meet these requirements. That means seven years of restricted lending. Does the Fed have any plans to offset the economic impact of what will be a long-drawn-out credit crunch?
Putting all this together we can see that there is a scary story here which the FT writer has completely missed. Banks will continue to be allowed to define their own risk weightings, inevitably leading to insufficient capital allocation against risky instruments – just as in the run-up to the 2008 financial crisis. Banks will be encouraged, through one-size-fits-all capital requirements, to buy the sovereign debt of weaker nations in preference to stronger ones – just as in the run-up to the current sovereign debt crisis. And in order to build up capital buffers, banks will be discouraged from lending to poorer risks such as SME’s – just when the economy really could do with an expansion of SMEs to create jobs. Wonderful.
Mind you, if you think the US story is scary, just look at this chart:

(h/t cigolo and @nr_zero for this one!)

These are, of course, European banks. And their capital shortfall is MUCH worse. The total shortfall is 77bn Euros just for these banks, which is by no means all of them: when smaller banks are included, the total shortfall is a massive 178bn Euros. Deutsche Bank alone is short of 10.5bn Euros. And no-one (except, to be fair, the UK) has any serious plans to recapitalise them.
That’s the REALLY scary story.