Mirable Dictu! US Regulators Impose Tougher Rules on Bank Capital

It’s easy to be cynical about the state of bank regulations, since the regulators themselves have for the most part been badly captured by the industry. So it’s important to give them credit when they take a meaningful step in the right direction.

Readers of Sheila Bair’s book Bull by the Horns may recall that one of her big fights was to implement a simple leverage ratio as the test of the adequacy of bank capital. Of course in banking nothing is simple; we’ll get to some of the complexities in due course. The original Basel accords, and Basel II, which had been implemented in Europe before the crisis and went live in the US in 2008, allow banks to risk weight their assets for the calculation of how much capital they need to hold against it. Certain assets, like sovereign debt, carried a zero risk weight (as in banks had to hold no capital against it) and AAA mortgage securities had a low risk weight. Guess what banks loaded up on?

Bair determined that banks that looked to have a decent level of capital per the Basel accords but were highly levered when measured by a simple equity to total assets ratio were the ones most likely to fail. She enlisted the Fed’s Danny Tarullo to campaign for a simple leverage ratio. They got 3% into Basel III, which was better than nothing but short of what they wanted.

Remarkably, today the Fed, FDIC and Office of the Comptroller of the Currency announced that the US was implementing a 5% simple leverage ratio for big bank. From the OCC’s press release:

The final rule applies to U.S. top-tier bank holding companies with more than $700 billion in consolidated total assets or more than $10 trillion in assets under custody (covered BHCs) and their insured depository institution (IDI) subsidiaries. Covered BHCs must maintain a leverage buffer greater than 2 percentage points above the minimum supplementary leverage ratio requirement of 3 percent, for a total of more than 5 percent, to avoid restrictions on capital distributions and discretionary bonus payments. IDI subsidiaries of covered BHCs must maintain at least a 6 percent supplementary leverage ratio to be considered “well capitalized” under the agencies’ prompt corrective action framework. The final rule, which has an effective date of January 1, 2018, currently applies to eight large U.S. banking organizations that meet the size thresholds and their IDI subsidiaries. The final rule is substantively the same as the rule proposed by the banking agencies in July 2013.

simple leverage ratio is 6% in the banks’ federally insured depositaries, which is where they’ve chosen to park risky derivatives positions.

Moreover, the difference between the more permissive European view of what gets counted as a balance sheet exposure and the US posture is not trivial. Matt Levine at Bloomberg looks at Morgan Stanley, the bank that will come up the most short despite having Tier 1 capital of 7.3% relative to its audited financials. But that’s not how regulators look at it:

Thinking about the actual size of a bank’s assets will lead to madness. There’s nothing actual about a bank. A bank is a pure creature of accounting; how much of it there is depends entirely on what you are trying to measure. One form of measurement is U.S. generally accepted accounting principles, which have their purposes, one of which is to be included in publicly released financial statements. Under U.S. GAAP, Morgan Stanley has $832.7 billion of assets, and so Morgan Stanley tells you that that’s how many assets it has.

Another form of measurement is the thing used to calculate the leverage ratio. This manages to find rather more assets at Morgan Stanley. Where does it find them? Oh, places. Generally, the new rule counts “total leverage exposure” to include:

• GAAP assets;
• potential future exposures for derivatives;
• other adjustments for derivatives to back out some cash collateral netting;
• lending commitments;
• sold credit protection;
• “repo-style” transactions;
• “all other off-balance sheet exposures”; and
• probably some other things too?

So you just dump all those things on the table, without risk-weighting them, and … wait no hang on that’s not true either. The claim that assets are not risk-weighted for the leverage ratio turns out to be totally untrue. GAAP assets are, for these purposes, assigned a risk weighting of 100 percent, whether they’re Treasuries or junk bonds. But everything else gets its own specialized weight. Lending commitments are risk-weighted at 10 percent of the amount of the commitment. Derivatives are weighted at 100 percent of notional, for sold credit derivatives,4 or 10 percent, for bought high-yield credit derivatives or 5+ year equity derivatives, or 8 percent, for 1-5 year equity derivatives or 5+ year precious metal derivatives (except gold, which is risk-weighted at 7.5 percent), or 6 percent, for 1-year-or-less equity derivatives, or 5 percent, for bought investment-grade credit derivatives or 1-5 year foreign exchange derivatives, or 1.5 percent, for 5+ year interest rate derivatives, or … you get the idea. Or do you? Is there an idea?

Risk Magazine, which was correctly worried that these tougher rules were likely to be implemented, flagged what businesses would be most affected:

Banks have since downplayed the impact during earnings calls, but the tougher ratio will deal a heavy blow to certain businesses – custody, repo and derivatives trading, for example.

What can banks do about it? Well, when it comes to derivatives, one option is to clean house. Swap portfolios invariably comprise layer upon layer of partially offsetting trades that amount to a relatively small net risk position, but it’s the gross number that matters from the point of view of the leverage ratio. So, tearing up unnecessary positions can be a big help, and many dealers have thrown a lot of energy into this compression process over the past year. But as well as being a science, this is also an art – and one that smaller institutions admit they have not yet mastered.

US regulators had from time to time said they wanted to make it more costly and difficult to be too big to fail; this is one way to go about it. The New York Times reports that regulators estimate that the banks subject to this rule will have to raise as much as $68 billion in capital by 2018. They can do that by selling new equity, shedding operations by selling them, shrinking their balance sheets, or retaining more earnings. The most logical route, if banking weren’t an exercise in looting, would be to retain more earnings, which means lowering pay levels. But that may wind up happening regardless as formerly attractive-looking business become less so under the new rules.

John Cassidy at the New Yorker discussed how this new rule was implemented despite the usual vigorous financial lobbyist campaign against it, but that this could augur in more restrictions on banks’ freewheeling ways:

The new requirements certainly don’t rule out the possibility of another banking crisis, and they don’t solve the too-big-to-fail model. But they make the former less likely, and they go some way toward addressing the negative externality that lies at the heart of the latter. Another promising thing about them is that they can be further developed. Once you accept the logic of beefing up capital requirements, there is nothing sacred, or particularly persuasive, about stopping at five per cent…

In her statement, Yellen talked about extending the new rule to international banks that are active in the United States, a possibility that would be allowed under the latest version of Basel III. Daniel Tarullo, a Fed governor who has been one of the strongest proponents of using capital requirements as a regulatory tool, reiterated his call for a surcharge on “risk-based” capital, which could discourage the big banks from relying on short-term funding that tends to dry up in a crisis. These are both eminently reasonable ideas, and a few years ago I would have said that they had little chance of being enacted. But the new rule shows that some progress is indeed possible.

While one robin does not make a spring, this is an important, and unambiguously positive development. Giving the authorities credit for moving in the right direction will encourage them to do more of the same.

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  1. Jesper

    How does the amount of equity to be raised before 2018 compare with the yearly subsidy of being too big to fail?

  2. susan the other

    “There’s nothing actual about a bank.” This little post explains more to me about banking than anything I have read. Not that I understood it… but I groked it. Pretty ironic that the biggest liability to be hedged with higher reserves is the actual accounting process (#1), followed closely by derivative exposure. They will now focus on a 5 or 6% ratio to protect depositaries because that is where the derivatives are parked? They should just put those derivatives in a different compartment, maybe the Quarantined Section of the bank.

    1. Yves Smith Post author

      Steve Waldman said the same thing three years ago, and I think you’d find it more accessible:

      This logic inverts for complex financials. Financial firms raise and generate liquidity routinely. Many of their assets are suitable as collateral in repo markets. Large commercial banks borrow freely in the Federal Funds market and satisfy liquidity demands in part simply by issuing deposits that are not immediately withdrawn. For large financial firms, access to liquidity is rarely contingent upon a detailed audit by a potential liquidity provider. Instead, access to liquidity, and the ability to continue as an operating firm, is contingent upon the “confidence” of peer firms and of regulators. Further, the earnings of a financial firm derive from the spread between its funding cost and asset yields. Funding costs are a function of market confidence, so the value of a financial firm’s real future earnings increases with optimistic valuation. For a long-term shareholder of a large financial, optimistically shading the firm’s position increases both the earnings of the firm and the “option value” of the firm in difficult times. It would be a massive failure of corporate governance if Jamie Dimon or Lloyd Blankfein did not fib a little to make their firms’ books seem a bit better than perhaps they are, within legal and regulatory tolerances.

      So, for large complex financials, capital cannot be measured precisely enough to distinguish conservatively solvent from insolvent banks, and capital positions are always optimistically padded. Given these facts, and I think they are facts, even “hard” capital and leverage restraints are unlikely to prevent misbehavior. Can anything be done about this? Are we doomed to some post-modern quantum mechanical nightmare wherein “Schrödinger’s Banks” are simultaneously alive and dead until some politically-shaped measurement by a regulator forces a collapse of the superposition of states into hunky-doriness?

      Yes, we are doomed, unless and until we simplify the structure of the banks. When I say stuff like “confidence intervals surrounding measures of bank capital are greater than 100%”, what does that even mean? Capital does not exist in the world. It is not accessible to the senses. When we claim a bank or any other firm has so much “capital” we are modeling its assets and liabilities and contingent positions and coming up with a number. Unfortunately, there is not one uniquely “true” model of bank capital. Even hewing to GAAP and all regulatory requirements, thousands of estimates and arbitrary choices must be made to compute the capital position of a modern bank. There is a broad, multidimensional “space” of defensible models by which capital might be computed. When we “measure” capital, we select a model and then compute.


      1. allcoppedout

        What science would stick itself with a measurement system that prevents – er – measurement?

        1. skippy

          Time travel is difficult, you never know what verse you’ll end up in.

          skippy…. tho being the travel agent can make you rich.

  3. allcoppedout

    I should coco. Tougher capital ratios?

    It is a form of capital that regulators hope could help buttress a bank’s finances in times of stress. CoCos are different to existing hybrids because they are designed to convert into shares if a pre-set trigger is breached in order to provide a shock boost to capital levels and reassure investors more generally. Hybrids, including CoCos, contain features of both debt and equity. They are intended to act as a cushion between senior bondholders and shareholders, who will suffer first if capital is lost. The bonds usually allow a bank to either hold on to the capital past the first repayment date, or to skip paying interest coupons on the notes.
    In the case of Lloyds bank, the trigger is if its core tier one capital ratio falls below 5 per cent. Conversion of its CoCos would push the ratio above 6.5 per cent.

    Grab your mug of coco and feel reassured. Cocos may be the instrument of the next collapse. You would have to hedge against banks not paying coupons – and in this case this would not trigger a credit event. Do you really want to swap your high yield coco for equity in a stressed bank? Coco conversion will be as obvious as big queues outside Northern Rock. You’d want out. So your coco will be derivatised.

    All talk on bank capital is semantic. Any real scheme to increase ratios would reduce returns and competitiveness. The invitation to coco is an invitation to bail-into-equity just at that point when confidence is collapsing. Very Cyprus.

    1. F. Beard

      Haven’t I always said that common stock was an (the?) ideal private money form? But the joke is that the banks ONLY want to share the losses and not the gains!

      Getting this society to recognize the need for ethics in purchasing power creation is harder than pulling impacted wisdom teeth. Well, it’ll learn or burn is my guess.

      1. allcoppedout

        Nice to see you Beard. I think we could do with some Puritanism. They got a bad press. I fear that even ‘economics as if people mattered’ still lacks – er – people.

  4. Adam1

    Having higher capital ratios is laughable. It assumes away any fraud. Capital is just an accounting residual. If your asset values are fraudulently over priced/valued then raising the capital requirement only requires you to make the lie a bigger lie.

  5. Fiver

    The banks would have no problem at all raising the necessary $68 billion by Jan 2018 assuming mafia-style ‘business as usual’ – however, the fact is they are going to be scrounging for hundreds of billions well before then as the non-financialized portion of the global economy diverges so far from market financials’ claims on it the host has been all but bled dry. And once the BRICS and other important players already completely alienated by truly detestable US policy choices financial, military, security, trade, legal, etc, finanalize their work on their non-dollar trade regimes, the US is going to find itself rather awkwardly looking for allies – of course of those allies, none any longer trusts the US not to go off half-cocked looking for new wars, instead of finally and truthfully ending existing ones. As of now, the US can only claim serious support from Canada (a political aberration), Israel, and the Bank of England. That’s it.

    1. alex morfesis

      when americans start paying 50 thousand dollars to illegally emigrate to Brazil, Russia, India or China is the day I will begin to worry about the dollar…

      if you didn’t notice…folks living in the Bric countries don’t seem to be as confident about their future as you seem to be…

      till then, please pass me those treasuries…
      they go good with these derivatives…

      pretty tasty…

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