This month will be busy for financial regulators as they convene to strike an international agreement — called Basel III — on new capital requirements for the world’s biggest banks and financial firms.
According to the draft proposal, global banks would be required to hold high-quality capital reserves, known as Tier 1 capital, at 9 percent of their total assets. That’s more, for instance, than the 7.5 percent Tier 1 capital target that Citigroup had set for itself during the height of the financial crisis. (The Tier 1 capital ratio is a crucial measure of a banks’ strength or weakness. The more capital that’s set aside, the less likely it is to fail, or at least that’s the idea.) Felix Salmon at Reuters has called the numbers in the draft proposal “definitely at the top end of what anybody expected.”
Depending on the country, this could make banks worry about the degree to which they cut into their profits. (As we’ve pointed out previously, banks generally hate having to set aside capital as buffers or to cover potential losses because it means those funds can’t be used for loans or further investments.)
[It] was the equivalent of standing tippy-toe at a concert, [fund manager John Hempton] argued. It might work for a single person trying to get a better view, but pretty quickly everyone’s doing it. In which case they all end up seeing as little as they did when everyone was sitting, but now everyone’s also uncomfortable to boot.
In banking, standing on tippy-toe entailed taking on too much leverage, according to Hempton. As long as only one firm did it, that firm could rake in additional profits. But when everyone was doing it, not only did competition drive spreads, and therefore margins, right down, but risk was ratcheted up. Which, in the end, proved very ugly for shareholders.
In other words, if all the banks are forced to get off their tippy-toes, no one will be at a competitive disadvantage, and the system as a whole will probably be more stable. (Of course, there are ways to artificially increase capital ratios. As Simon Johnson and James Kwak, authors of the financial blog The Baseline Scenario, pointed out, Lehman Brothers was “more than adequately capitalized on paper” with a Tier 1 capital ratio of 11.6 percent before it went bankrupt.)
Reaction to the proposed rules is mixed. German banks, for instance, will likely be among the most strained by the new rules, while Indian banks don’t expect to be significantly affected, because their capital ratios are already around the 9-percent level.
Generally, bankers and regulators disagree on how the new rules will affect the economy, reported Reuters, with banking execs arguing that tougher regulations will curb growth. Executives from the world’s leading banks are also meeting to discuss the looming regulation this week.