With U.S. financial reform nearly through, eyes are turning to the Basel Committee on Banking Supervision, which is hammering out a set of regulatory standards intended to lay the foundation for a global overhaul.

Their expected cost has received most of the attention — UBS analysts have estimated the plan would require global banks to raise $375 billion in new capital.

But how the standards shape regulators' approach to measuring bank safety will be just as important. Though the Basel committee has recommended as-yet-undefined restrictions on a bank's overall leverage, it is moving toward enshrining a set of risk-based capital requirements that would force banks to apportion capital according to each asset type's designated risk.

There is reason to doubt whether such rules would do much to prevent another crisis. Though they are supposed to provide a more nimble measure of risk than a blanket prohibition against financing too many assets with too few dollars of equity, previous efforts to fine-tune them have backfired.

Such risk-based capital approaches provide an incentive for arbitrage in which banks distort their investment portfolios in the surreptitious pursuit of yield and mask the risk through capital-markets transactions.

Moreover, to be effective, capital rules would have to address the shadow banking system, effectively making sure that measured risk isn't pawned off on entities outside the system.
That isn't to say regulatory capital standards can't work. But given the rewards for inventing new workarounds, preventing the rules from being gamed will require stronger judgment, muscle, coordination and flexibility than regulators have consistently mustered in the past.

"Our records are full of 'capitally adequate' banks that failed," said Dennis Santiago, managing director of Institutional Risk Analytics, a firm that evaluates bank health.

The Basel III rules, he said, are "stiffened versions of exactly the kinds of mathematical formulae that I would argue helped create the crisis in the first place."

It's not that the rationale for higher capital requirements doesn't make practical and theoretical sense. When a crisis arrives, a bank with more capital will fare better than an identical institution with less padding. And requiring a bank's owners to put more of their own money on the table should lessen a long-recognized moral hazard: A bank's owners get to keep the upside of socially undesirable gambles but can only lose the sum they've invested.

"The theory of it is that if you take away all the perverse incentives, requiring more capital is going to be more costly to fill, and make the banks take less risk," said Luc Laeven, a researcher at the International Monetary Fund who broadly favors the Basel III approach.

The current proposals would require banks to hold more capital against their risk-weighted assets, but the percentage hasn't been set. As is currently stands, government debt would be considered riskless and other types of assets would be weighted according to their perceived safety.

The legacy of the financial crisis is readily apparent in some categories: resecuritized products, such as CDOs, are penalized. In others, it's a little less obvious: housing is weighted at 35%, implying safety.

But the history of compliance with such rules has often ended at the letter, not the spirit. Though American banks' troubles can't be pinned on Basel II — the U.S. never adopted it — large U.S. banks proved adept at putting together portfolios that exceeded regulatory capital requirements while chasing yield in housing, structured finance, and other areas.

When regulators bailed out Citigroup at the end of 2008, the company boasted a robust Tier 1 risk-based capital ratio of 8.2% and total regulatory capital of 11.6%.

Across the board, capital markets offered large banks lower-weighted alternatives to standard lending, allowing them to sharply increase their assets.

More disconcerting than ineffectiveness, however, is the prospect that ginned-up regulatory capital levels may be correlated with recklessness.

A paper published in the Organization for Economic Cooperation and Development Journal Financial Market Trends found that, on a country-by-country basis, banking sectors with high regulatory capital ratios entered the crisis with more leverage and took far greater losses than those with supposedly worse capital positions.

Swiss, German and Belgian banks, for example, boasted the best Tier 1 ratios among 12 nations studied. Yet they also maintained the highest unweighted leverage and eventually suffered the worst losses, 1.5% to 2.5% of total assets. Italian banks had poor Tier 1 capital levels but far less leverage — and lost much less in the crisis.

One possible explanation, the authors wrote, is that strong capital ratios provided a false sense of security as leverage spiraled out of control. Another is that highly levered balance sheets and the fig leaf of strong regulatory capital are "symptomatic of a banking culture with greater willingness to take on more risk with taxpayers' money — a culture of privatizing gains and socialising losses."

Another sticking point in the U.S. is figuring out how to prevent measurable risk from accumulating in hedge funds, insurers, and other players operating in regulatory blind spots.
Though the Financial Stability Oversight Council would have the theoretical ability to extend Federal Reserve regulation to wherever is necessary, "it's not at all clear what nonbank institutions the Fed may be able to regulate," said Dwight Smith 3rd, a partner at Alston & Bird. "To the extent that this is a problem, the solution is only going to emerge over a few years and not anytime soon."

It's partly for that reason that attention is starting to shift toward a leverage cap as a necessary counterpart to risk-based rules. While an amendment to impose a 15:1 limit was stripped from the reform bill, "there's a lot more focus than there was" on the topic, Smith said. "The beauty of a leverage ratio is that it doesn't matter where a bank moves something."

The Basel Committee will finish a two-day meeting today. Its proposals are meant to be ready for the G20's next meeting in the fall. It's unclear whether the proposals will lean more toward the leverage- or risk-based approaches.

The Federal Deposit Insurance Corp. and the Treasury Department have endorsed a leverage cap of some form; European banks and regulators have largely opposed it.

Both Smith and Laeven said there's merit to combining leverage- and risk-based capital limits.
"These two things are taken to be the same, but they are not," Laeven said. "The outcome, especially in the case of losses, is going to be very different."

Subscribe Now

Access to a full range of industry content, analysis and expert commentary.

30-Day Free Trial

No credit card required. Access coverage of the securitization marketplace, including breaking news updated throughout the day.