naked capitalism

Bloomberg did not report this story in enough detail to be certain, but as it reads, the EU will be imposing rules on member banks that will require them to hold more capital now.

That’s a good thing, right? Banks need more capital, after all.

Not exactly, When banks are imperiled, the first priority is to try to get them back to the level of capital considered necessary before they went into crisis, but offer some latitude if it looks like they are good citizens (or have decided to clean up their act if they misbehaved) and have a realistic chance of pulling through. As a matter of form, regulators use various methods to cut them some slack. The term of art is regulatory forebearance.

Some of the approaches are debatable. For instance, the move in the US to let banks fudge the value of infrequently traded assets looks to be a bad idea. Counterparties already don’t trust each other, so why let financial firm get more creative with their accounting? This initiative could well be counterproductive.

Now a newly-popular theory is that capital requirements should be pro-cyclical. Just as banks get a break in bad times, they should be asked to sock away even more capital in really robust times. That would help prevent asset bubbles too. While it sounds hard to implement, there are some ideas that have been worked out in some detail that sound viable.

However, asking banks in a credit crunch to increase their capital (not to fill shortfalls, but by imposing higher standards) is draconian and likely to worsen the credit crunch. Yet that is what the EU appears to be preparing to do by imposing higher capital requirements on asset backed securities.

Mind you, we are not objecting to the concept, but how it is implemented, Putting it in place shortly runs counter to normal regulatory practice, which is why we suspect Bloomberg may have omitted some key details.

For instance, the EU may apply the new, tougher standards to newly acquired ABS, and have a phased-in implementation for existing positions. Or they may calculate the ratios using the new metrics, but not base enforcement on those ratios for a transition period. But as it reads the EU measure is surprising.

But this may be exactly what it appears to be. As John Dizard noted in the Financial Times:

So the central bankers, and, by extension, taxpayers, will be underwriting the present system for some time.

Not that they are happy about it, and their unhappiness will be expressed through harsher capital ratios and the forcing of common equity issuance on ever-worse terms. You can expect more contradictory public policies, such as calls for restimulation of the economy accompanied by regulatory insistence on putting more securitisations on the balance sheet, reducing lending capacity.

From Bloomberg:

European Union banks will have to hold more capital for asset-backed bonds as part of a regulatory overhaul proposed today in response to the worst financial crisis since the Great Depression.

Charlie McCreevy, EU financial-services commissioner, advanced measures to tighten the oversight of lenders and curb practices such as selling off questionable loans to investors that led to a global credit crunch and record bank losses….

McCreevy’s proposal seeks higher capital standards for the securities built out of loans or other assets, referred to as structured finance, at the heart of the market turmoil. Lenders also would get stricter limits on the size of any individual risk they take on, even if from another bank.

The measure also seeks to tighten cooperation among regulators, with each multinational bank overseen by a college of the authorities from every country where it does business…..

“Capital requirement reductions for risk mitigation in the past haven’t always reflected reality and regulators are to some extent catching up with that, said Derek Chambers, an analyst at Standard & Poor’s Equity Research Ltd. in London. “Making the capital requirements responsive to risk is right. Not allowing artificial devices to arbitrarily reduce regulatory capital is right. But I’m not sure that altering one little piece of the jigsaw is going to solve everything.’