Bank rules need more than fine-tun­ing

The Register Citizen (Torrington, CT) - - OPINION -

Hav­ing spent nearly a decade craft­ing new cap­i­tal re­quire­ments to bol­ster the re­silience of the coun­try’s largest banks, the U.S. Fed­eral Re­serve is get­ting ready to do some fine-tun­ing. The rules can cer­tainly be im­proved — but what’s needed is more than tin­ker­ing around the edges.

The Fed has two main tools to en­sure banks have enough eq­uity cap­i­tal, the bedrock fi­nanc­ing that lets them ab­sorb losses and con­tinue lend­ing in dif­fi­cult times. It sets min­i­mum lev­els, and it con­ducts an­nual stress tests to see whether the thresh­olds would be breached in a cri­sis. Its new idea is to link the two to­gether — us­ing the tests to help ad­just the lev­els.

Cur­rently, if a bank flunks a stress test, the Fed re­stricts how much eq­uity can be given back to share­hold­ers — in the form of div­i­dends and share buy­backs — un­til the bank is bet­ter cap­i­tal­ized. Under the Fed’s new pro­posal, banks that suf­fered big­ger losses in the tests would au­to­mat­i­cally face higher cap­i­tal re­quire­ments, hence stricter lim­its on their pay­outs.

This is a good idea as far as it goes. Banks that take on more risk need more cap­i­tal to ab­sorb the po­ten­tial losses. To­gether with other tweaks to the stress tests, the pro­posal might boost some of the largest banks’ cap­i­tal re­quire­ments by some tenths of a per­cent­age point, while re­duc­ing re­quire­ments for smaller banks that don’t have global trad­ing op­er­a­tions.

Such fine-tun­ing, how­ever, fails to get to grips with the big­ger prob­lem. Taken to­gether, ex­ist­ing cap­i­tal re­quire­ments and stress tests still aren’t enough to pre­pare banks for a real cri­sis. As soon as peo­ple start to think a bank is go­ing bust, it’s doomed. So it needs enough eq­uity to ab­sorb se­vere losses and con­tinue op­er­at­ing. The largest in­sti­tu­tions cur­rently have as lit­tle as $6 in eq­uity for each $100 in as­sets. Re­search by the Min­neapo­lis Fed sug­gests that they would need more than twice that amount to make dis­as­ter ac­cept­ably un­likely.

The Fed’s plan to link cap­i­tal and stress tests does lit­tle to ad­dress that — and an­other new pro­posal moves in the op­po­site di­rec­tion. Reg­u­la­tors want to weaken the so-called sup­ple­men­tary lever­age ra­tio, a back­stop de­signed to make sure banks have a min­i­mum amount of eq­uity no mat­ter how safe they be­lieve their as­sets to be. The aim is to tai­lor this re­quire­ment to banks’ sys­temic im­por­tance — again, a good idea in it­self — but the ef­fect will be to re­duce re­quired cap­i­tal at some of the coun­try’s largest de­pos­i­tory in­sti­tu­tions by an es­ti­mated $121 bil­lion.

Reg­u­la­tion should be smart and no more bur­den­some than nec­es­sary. The Fed is right to seek im­prove­ments in an un­duly com­plex sys­tem. But these plans miss the most im­por­tant point: The goal should be to en­sure that when the next cri­sis comes, the fi­nan­cial sys­tem will be a source of strength, not fragility.

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