Capital Requirements

By Patrick Corby

Hoenig

The Federal Deposit Insurance Corporation (FDIC) Director and famed regulator, Thomas Hoenig has predicted that the US will run into the same financial woes of 2007 if it continues on the track it is on. He stated on the 30th November at a national conference on capital requirements held in New York that banks underlying capital should be raised to 10% from the current 2.8% held.

Talking to Bloomberg Hoenig said:

“The behavior and practices leading to this crisis will soon reemerge and these highly complex, more vulnerable firms will have an even more devastating effect on the economy.”

He stressed that public money, as directed by the FED, is at risk of losing it’s purchasing power once again when the next financial turn down occurs, due to the low capital underlying the operations of financial institutions.

He stressed that public money, as directed by the FED, is at risk of losing it’s purchasing power once again when the next financial turn down occurs, due to the low capital underlying the operations of financial institutions.

Hoenig emphasises that the US is in a very similar position to that of before the deflationary crisis of 2007 was realised, allowing risk structure to be managed by a protectionist safety net for those uninhibited in gearing up leverage and increasing debts. Hoenig is now asserting that the framework in which the US regulates capital must change in order to protect public money from being manipulated in order to save those unwilling to protect themselves.

In a speech made at the conference he called for three changes in the economic framework in which the US is operating:

  1. A narrowing of the public safety net and contraction of subsidies to indebted firms

Commercial banks have been protected by the FED under the ruse that they cannot be allowed to fail. The US government has slid into the position of bolstering the confidence of the public that they can access their money at any point from the bank. This has led to deposit insurance, government loans and government support for financial institutions.

The state designed safety net undermines the essential workings of the market economy and allows for the wrong incentives to play out. ‘Market discipline‘ breaks down as responsibility is saturated throughout the economy instead of in a firm or individual hands. This interventionist system allows the public to take on the risk for the banks giving them free rein in their market actions. Thomas Hoenig asks for a market framework where government protects infrastructure and does not allow banks to play risk free with public money.

Market discipline works best when stockholders and creditors understand they are at risk and when the safety net is narrowly applied to the infrastructure for which it was intended.”

  1. A strengthening of capital standards to restrict leverage and a build up excessive debt to act as a absorber of financial shock.

In 2007, when the speculative bubbles started to deflate, capital requirements under the Basel standard were at a unfathomably low 2.8% in individual tangible capital.

Using ‘risk-weighed asset’ analysis, the top 5 banks had capital of 11% underlying operations. This level of capital, if held in tangible assets, would have severely dampened the onset of the crisis but most of the ‘risk-weighed’ assets examined were contractual abstract assets not yet held. This methodology of auditing only served to skew balance sheets and move credit expansion to even greater heights.

Had [tangible assets] been the primary capital measure in 2007, it is likely that far more questions would have been asked about the soundness of the industry, resulting in a less severe banking crisis and recession.” says Hoenig.

At present levels underlying capital for the 10 largest capital holding firms is at an average of 6%, still far below the average what historically the market agreed requirement has been. Before intervention became the norm financial institutions kept 13 – 16% in tangible capital to base operations.

Given this Hoenig states that a Basel standard of 10% minimum in tangible assets be held in capital requirements in order to keep operations stable.

  1. A more transparent framework in which to access the capital foundations of banks and holding companies.

The Basel standard has:three pillars: capital, market discipline, and an effective bank supervision program’. In his third point Hoenig pointed to the supervision of financial institutions and called for stronger overseeing of operations; higher risk banks should be met with higher capital requirements.

‘For example, a 10 percent minimum tangible capital ratio would be adequate for a 1-rated bank, while a bank whose risk profile is 2 rated might require a higher ratio, say 11 percent, and similarly a 3 rating might require say 13 percent. A bank rated more poorly would be under a specific supervisory action.’

What Hoenig does not answer is how state supervision, which requires systematic examination and audit of a banks balance sheets, will pull off this big brother type analysis. The point is that ‘the astute examination personnel needed when asset prices tumble are unwilling to submit to the boredom of the long periods before a crisis’ (Kindleberger 2011) – the project would call for colossal management.

Would this be Enough?

The moral-hazard argument is the best to shun off government intervention: That activities supported by the backdrop of governments distort risk–reward trade off in the market by reducing the likelihood of future losses.

A strong case can be made for far stricter regulation and supervision of banks to forestall lending when a speculative culture arises. Indeed, this is normally the universal reaction to financial crises. Yet regulations impose costs and in history this has been met with new institutions and instruments that cannot be subsumed under current regulations arising. This was the case with the offshore

market to avoid reserve requirements and deposit insurance premiums and reap instead higher interest.

In 1987 when Citicorp decided to write-down the value of third world loans, the Federal Saving and Loan Insurance Corporation (FSLIC) allowed some 500 insolvent banks to stay in operation to try and rebuild capital. This move caused the Federal Reserve to organise a structural requirement with the other G10 countries to strengthen the regulation surrounding capital requirements.

The reaction to higher percentage capital requirements for assets or liabilities gave an incentive for banks to move to ‘off balance sheet’ operations. Banks developed Special Investment Vehicles (SIV) that could manoeuvre around the new capital requirements. These operations used derivative instruments such as futures, forwards, options and underwriting risks to name a few each which can be valued as asset or a liability manipulating the appropriate capital requirements.

The argument is that more regulation above and beyond sustaining market infrastructure causes institutions and individuals to manoeuvre around burdensome red tape and develop new ways to profit. Over regulation in the past has only hampered the process and lead to a less structured financial system. While as Hoenig notes when left to its own market mechanisms surrounded by stable infrastructure markets found their own equilibrium in capital far higher than the present where intervention supposed to protect the system, indeed seem to be hampering and sending markets in the wrong direction.

We would be wise to think beyond added rules to fundamental change. We must narrow the safety net and confine it to the payments system, deposit taking, and the related intermediation of deposits to loans. We must simplify and strengthen the capital standards and then subject all banks to the same standard of measurement and performance. And finally, we must reintroduce meaningful examination programs for the largest firms. These steps, taken together, would do much to assure greater stability for our financial system.’

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4 thoughts on “Capital Requirements

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