The new capital rules that were approved by the Federal Reserve, but are still open for comment, on Thursday are being portrayed as a big blow to the banks. The Fed basically sided with international regulators. The banks were pushing for U.S. regulators to be more lenient. Do they remember who started the financial crisis?
Based on the new rules, banks have to have on hand at least 7% of their loans and other investments, after adjusting for riskiness. In the past, the regulators deemed a bank healthy if it had capital equal to 5% of its loans, again adjusting for risk. So the new rules will require banks to hold more capital than they were required to hold in the past, but it’s not much more than what the banks have now. Citigroup (C), for instance, now has a tangible equity-to-assets of 7.7%. So the new rules, at least for now, will mean that Citi can take on more risks, not less. The big banks will have to eventually hold even more capital than the 7%, perhaps as much as 9.5%. But those rules won’t be finalized until 2014, and won’t go into effect until 2016. So it’s business as usual, London Whales and all, for another four years at least.
Critics of the rules have said that banks have to be allowed to take risks. Don’t worry. Banks will still be allowed to make plenty of ill-advised loans. After the financial crisis, people were shocked to find out that banks were able to lend out $30 for every $1 in capital they had on hand. Under the new rules, the banks will still be lending out $14 for every $1 in capital they hold. Put another way, the banks end up out of business if on average two out of every 14 loans they make go bust. Seems like the banks are still plenty risky.
Telling is the response I got from H. Rodgin Cohen, who is a partner at Sullivan and Cromwell and the banks go-to lawyer for all things, well, all things. He said the banks weren’t really fighting the Fed over the 7% capital rule. In fact, the stuff the banks put up the most fight about was the ability to count mortgage servicing rights as an asset and rules that would require them to mark their loans to market — nitty-gritty details that the rest of us don’t think much about, but get to the heart of the problem with capital rules. They are based on banks’ and regulators’ judgment of how risky particular loans are. But inevitably banks and regulators are going to get that wrong. The reason financial crises occur is because the loans and bets that banks make don’t end up being nearly as safe as we thought.
For that reason, many think the banks are getting off easy. Anat Admati, an economics professor at Stanford Graduate School and an expert on bank regulations, says the capital ratios that regulators are proposing aren’t even in the right ball park. A recent research paper from the Bank of England puts the optimal bank capital level – the level at which you eliminate systemic risk, but still have a healthy loan market – at 20%.
The one rule that perhaps has a little bit of promise that the Fed put out yesterday is one that requires banks to hold capital equal to 3% of not only all their loans, no matter how risk-less we think they might be, but also derivatives and off-balance sheet obligations. Right now, banks don’t have to put anything aside for risky derivatives. This could require banks to hold much more capital than they do now. But 3% is still low, and there is a question of how you measure derivative risk. JPMorgan Chase (JPM), for instance, has derivative bets with a notional value of $73 trillion. How much would you make JPMorgan reserve against that? Even 0.5% is $365 billion. JPMorgan couldn’t come up with that kind of cash. But JPMorgan will tell you that the real amount that it has at risk in its derivative portfolio is just $66 billion. Three percent of that is just $2 billion, which is the same amount the London Whale was able to swallow in about a month.
Admati believes that at the very least banks should be forced to suspend their dividends until they have enough capital to meet the new requirements. It’s not like the banks are using their excess capital to make loans these days. Says Admati, “If we want to get to a particular level, why move away by allowing payouts? There is no problem and no justification except that the banks don’t like it.” And doing what the banks like is what got us into this mess in the first place.