Posts filed under “Regulation”
> My Sunday Washington Post Business Section column is out. This morning, we look at the question: Can two senators end ‘too big to fail’? Here’s an excerpt from the column: “Just how much of a subsidy are the banks receiving? An International Montetary Fund Working Paper quantified it as creating an 80 percent…Read More
Sherrod Brown (D-Ohio), along with unlikely ally Sen. David Vitter (R-La.), is launching an effort to break up the big banks and release their hold on politicians and the American economy. But how will he manage such an arduous task? What is the Obama administration’s take on this? Are there any politicians willing to join in the effort to stop the “too big to fail” mentality and stop subsidizing the banks? What progressive efforts can be passed in the Senate?
Vitter interview on BLoomberg
Interesting war of words between Texas governor Rick Perry and SacBee’s cartoonist Jack Ohman. Perry is demanding the cartonist be fired for his insensitivity to the deaths at the fertilizer plant. Ohman responded: “When you have a politician traveling across the country selling a state with low regulatory capacity, that politician also has to…Read More
“It is a smart, simple and tough piece of work that would protect taxpayers from costly rescues in the future. This means that the bill will come under fierce attack from the big banks that almost wrecked our economy and stand to lose the most if it becomes law.” -Gretchen Morgenson, NYT “It’s clear…Read More
Rethinking Macro Policy II
Governor Jeremy C. Stein
International Monetary Fund, Washington, D.C. April 17, 2013
Regulating Large Financial Institutions
Thank you. I’m delighted to be here, and want to thank the International Monetary Fund and the organizers of the conference for including me in a discussion of these important topics. I will focus my remarks today on the ongoing regulatory challenges associated with large, systemically important financial institutions, or SIFIs.1 In part, this focus amounts to asking a question that seems to be on everyone’s mind these days: Where do we stand with respect to fixing the problem of “too big to fail” (TBTF)? Are we making satisfactory progress, or it is time to think about further measures?
I should note at the outset that solving the TBTF problem has two distinct aspects. First, and most obviously, one goal is to get to the point where all market participants understand with certainty that if a large SIFI were to fail, the losses would fall on its shareholders and creditors, and taxpayers would have no exposure. However, this is only a necessary condition for success, but not a sufficient one. A second aim is that the failure of a SIFI must not impose significant spillovers on the rest of the financial system, in the form of contagion effects, fire sales, widespread credit crunches, and the like. Clearly, these two goals are closely related. If policy does a better job of mitigating spillovers, it becomes more credible to claim that a SIFI will be allowed to fail without government bailout.
So where do we stand? I believe two statements are simultaneously true. We’ve made considerable progress with respect to SIFIs since the financial crisis. And we’re not yet at a point where we should be satisfied.
All of you are familiar with the areas of progress. Higher and more robust capital requirements, new liquidity requirements, and stress testing all should help to materially reduce the probability of a SIFI finding itself at the point of failure. And, if, despite these measures, a SIFI does fail, the orderly liquidation authority (OLA) in Title II of the Dodd-Frank Wall Street Reform and Consumer Protection Act now offers a mechanism for recapitalizing and restructuring the institution by imposing losses on shareholders and creditors. In the interests of brevity, I won’t go into a lot of detail about OLA. But my Board colleague Jay Powell talked in depth about this topic in a speech last month, and I would just register my broad agreement with his conclusion–namely that the Federal Deposit Insurance Corporation’s (FDIC’s) so-called “single point of entry” approach to resolution is a promising one.2 The Federal Reserve continues to work with the FDIC on the many difficult implementation challenges that remain, but I believe this approach gets the first-order economics right and ultimately has a good chance to be effective.
Perhaps more to the point for TBTF, if a SIFI does fail I have little doubt that private investors will in fact bear the losses–even if this leads to an outcome that is messier and more costly to society than we would ideally like. Dodd-Frank is very clear in saying that the Federal Reserve and other regulators cannot use their emergency authorities to bail out an individual failing institution. And as a member of the Board, I am committed to following both the letter and the spirit of the law.
Mike Konczal, fellow at the Roosevelt Institute and contributor to Bloomberg View, talks with Bloomberg Law’s Lee Pacchia about how the implementation of the financial reform laws in Dodd-Frank have been hampered by a series of adverse court decisions. Konczal contends that these decisions are not only a setback for proponents of reforming the financial industry, but also have a chilling effect on future efforts by regulators and lawmakers. At the same time, however, Konczal feels that these courthouse victories could end up harming the finance industry. “If it looks like the law is unable to do what it needs to you will see reformers come back with much harsher provisions…that the banks successful avoided the first time around,” he says.
Basel III Capital: A Well-Intended Illusion
Thomas M. Hoenig, FDIC Vice Chairman
International Association of Deposit Insurers 2013 Research Conference in Basel, Switzerland, April 9, 2013
Aristotle is credited with being the first philosopher to systematically study logical fallacies, which he defined as arguments that appear valid but, in fact, are not. I call them well-intended illusions.
One such illusion of precision is the Basel capital standards in which world supervisory authorities rely principally on a Tier 1 capital ratio to judge the adequacy of bank capital and balance sheet strength. For the largest of these firms, each dollar of risk-weighted assets is funded with 12 to 15 cents in equity capital, projecting the illusion that these firms are well capitalized. The reality is that each dollar of their total assets is funded with far less equity capital, leaving open the matter of how well capitalized they might be.
Here’s how the illusion is created. Basel’s Tier 1 capital measure is a bank’s ratio of Tier 1 capital to risk-weighted assets. Each category of bank assets is weighed by the supervisory authority on a complicated scale of probabilities and models that assign a relative risk of loss to each group, including off balance sheet items. Assets deemed low risk are reported at lower amounts on the balance sheet. The lower the risk, the lower the amount reported on the balance sheet for capital purposes and the higher the calculated Tier 1 ratio.
We know from years of experience using the Basel capital standards that once the regulatory authorities finish their weighting scheme, bank managers begin the process of allocating capital and assets to maximize financial returns around these constructed weights. The objective is to maximize a firm’s return on equity (ROE) by managing the balance sheet in such a manner that for any level of equity, the risk-weighted assets are reported at levels far less than actual total assets under management. This creates the illusion that banking organizations have adequate capital to absorb unexpected losses. For the largest global financial companies, risk-weighted assets are approximately one-half of total assets. This “leveraging up” has served world economies poorly.
In contrast, supervisors and financial firms can choose to rely on the tangible leverage ratio to judge the overall adequacy of capital for the enterprise. This ratio compares equity capital to total assets, deducting goodwill, other intangibles, and deferred tax assets from both equity and total assets. In addition to including only loss-absorbing capital, it also makes no attempt to predict or assign relative risk weights among asset classes. Using this leverage ratio as our guide, we find for the largest banking organizations that each dollar of assets has only 4 to 6 cents funded with tangible equity capital, a far smaller buffer than asserted under the Basel standards.
Table 1 [see below] reports the Basel Tier 1 risk-weighted capital ratio and the leverage ratio for different classes of banking firms. Column 4 shows Tier 1 capital ratios ranging between 12 and 15 percent for the largest global firms, giving the impression that these banks are highly capitalized. However, it is hard to be certain of that by looking at this ratio since risk-weighted assets are so much less than total assets. In contrast, Column 6 shows U.S. firms’ average leverage ratio to be 6 percent using generally accepted accounting standards (GAAP), and Column 8 shows their average ratio to be 3.9 percent using international accounting standards (IFRS), which places more of these firms’ derivatives onto the balance sheet than does GAAP.
The bottom portion of Table 1 shows the degree of leverage among different size groups of banking firms, which is striking as well. The Tier 1 capital measure suggests that all size groups of banks hold comparable capital levels, while the leverage ratio reports a different outcome. For example, the leverage ratio for most banking groups not considered systemically important averages near 8 percent or higher. Under GAAP accounting standards, the difference in this ratio between the largest banking organizations and the smaller firms is 175-250 basis points. Under IFRS standards, the difference is as much as 400-475 basis points. The largest firms, which most affect the economy, hold the least amount of capital in the industry. While this shows them to be more fragile, it also identifies just how significant a competitive advantage these lower capital levels provide the largest firms.
These comparisons illustrate how easily the Basel capital standard can confuse and misinform the public rather than meaningfully report a banking company’s relative financial strength. Recent history shows also just how damaging this can be to the industry and the economy. In 2007, for example, the 10 largest and most complex U.S. banking firms reported Tier 1 capital ratios that, on average, exceeded 7 percent of risk-weighted assets. Regulators deemed these largest to be well capitalized. This risk-weighted capital measure, however, mapped into an average leverage ratio of just 2.8 percent. We learned all too late that having less than 3 cents of tangible capital for every dollar of assets on the balance sheet is not enough to absorb even the smallest of financial losses, and certainly not a major shock. With the crisis, the illusion of adequate capital was discovered, after having misled shareholders, regulators, and taxpayers.
There are other, more recent, examples of how this arcane measure can be manipulated to give the illusion of strength even when a firm incurs losses. For example, in the fourth quarter of 2012, Deutsche Bank reported a loss of 2.5 billion EUR. That same quarter, its Tier 1 risk-based capital ratio increased from 14.2 percent to 15.1 percent due, in part, to “model and process enhancements”1 that resulted in a decline in risk-weighted assets, which now amount to just 16.6 percent of total assets.
On Feb. 1, SNS Reaal, the fourth largest Dutch bank with $5 billion in assets, was nationalized by the Dutch government. Just seven months earlier, on June 30, 2012, SNS reported a Tier 1 risk-based capital ratio of 12.2 percent. However, the firm reported a Tier 1 leverage ratio based upon international accounting standards of only 1.47 percent. This leverage ratio was much more indicative of the SNS’s poor financial position.
The Basel III proposal belatedly introduces the concept of a leverage ratio but calls for it to be only 3 percent, an amount already shown to be insufficient to absorb sizable financial losses in a crisis. It is wrong to suggest to the public that, with so little capital, these largest firms could survive without public support should they encounter any significant economic reversals.
I am intrigued by the issue of how our own cognitive foibles impacts our decision making processes as investors. Our behaviors have evolved for other reasons (primarily survival); Regular readers know I am especially interested in how our wetware fails us when applied to making risk decisions in capital markets. It is exceedingly difficult to avoid…Read More