Regulators Let Big Banks Look Safer Than They Are. By Sheila Bair
The Wall Street Journal, April 2, 2013, on page A13
http://online.wsj.com/article/SB10001424127887323415304578370703145206368.html
The recent Senate report on the J.P. Morgan Chase "London Whale" trading debacle revealed emails, telephone conversations and other evidence of how Chase managers manipulated their internal risk models to boost the bank's regulatory capital ratios. Risk models are common and certainly not illegal. Nevertheless, their use in bolstering a bank's capital ratios can give the public a false sense of security about the stability of the nation's largest financial institutions.
Capital ratios (also called capital adequacy ratios) reflect the percentage of a bank's assets that are funded with equity and are a key barometer of the institution's financial strength—they measure the bank's ability to absorb losses and still remain solvent. This should be a simple measure, but it isn't. That's because regulators allow banks to use a process called "risk weighting," which allows them to raise their capital ratios by characterizing the assets they hold as "low risk."
For instance, as part of the Federal Reserve's recent stress test, the Bank of America reported to the Federal Reserve that its capital ratio is 11.4%. But that was a measure of the bank's common equity as a percentage of the assets it holds as weighted by their risk—which is much less than the value of these assets according to accounting rules. Take out the risk-weighting adjustment, and its capital ratio falls to 7.8%.
On average, the three big universal banking companies (J.P. Morgan Chase, Bank of America and Citigroup) risk-weight their assets at only 55% of their total assets. For every trillion dollars in accounting assets, these megabanks calculate their capital ratio as if the assets represented only $550 billion of risk.
As we learned during the 2008 financial crisis, financial models can be unreliable. Their assumptions about the risk of steep declines in housing prices were fatally flawed, causing catastrophic drops in the value of mortgage-backed securities. And now the London Whale episode has shown how capital regulations create incentives for even legitimate models to be manipulated.
According to the evidence compiled by the Senate Permanent Subcommittee on Investigations, the Chase staff was able to magically cut the risks of the Whale's trades in half. Of course, they also camouflaged the true dangers in those trades.
The ease with which models can be manipulated results in wildly divergent risk-weightings among banks with similar portfolios. Ironically, the government permits a bank to use its own internal models to help determine the riskiness of assets, such as securities and derivatives, which are held for trading—but not to determine the riskiness of good old-fashioned loans. The risk weights of loans are determined by regulation and generally subject to tougher capital treatment. As a result, financial institutions with large trading books can have less capital and still report higher capital ratios than traditional banks whose portfolios consist primarily of loans.
Compare, for instance, the risk-based ratios of Morgan Stanley, an investment bank that has struggled since the crisis, and U.S. Bancorp, a traditional commercial lender that has been one of the industry's best performers. According to the Fed's latest stress test, Morgan Stanley reported a risk-based capital ratio of nearly 14%; take out the risk weighting and its ratio drops to 7%. USB has a risk-based ratio of about 9%, virtually the same as its ratio on a non-risk weighted basis.
In the U.S. and most other countries, banks can also load up on their own country's government-backed debt and treat it as having zero risk. Many banks in distressed European nations have aggressively purchased their country's government debt to enhance their risk-based capital ratios.
In addition, if a bank buys the debt of another bank, it only needs to include 20% of the accounting value of those holdings for determining its capital requirements—but it must include 100% of the value of bonds of a commercial issuer. The rules governing capital ratios treat Citibank's debt as having one-fifth the risk of IBM's. In a financial system that is already far too interconnected, it defies reason that regulators give banks such strong capital incentives to invest in each other.
Regulators need to use a simple, effective ratio as the main determinant of a bank's capital strength and go back to the drawing board on risk-weighting assets. It does make sense to look at the riskiness of banks' assets in determining the adequacy of its capital. But the current rules are upside down, providing more generous treatment of derivatives trading than fully collateralized small-business lending.
The main argument megabanks advance against a tough capital ratio is that it would force them to raise more capital and hurt the economic recovery. But the megabanks aren't doing much new lending. Since the crisis, they have piled up excess reserves and expanded their securities and derivatives positions—where they get a capital break—while loans, which are subject to tougher capital rules, have remained nearly flat.
Though all banks have struggled to lend in the current environment, midsize banks, with their higher capital levels, have the strongest loan growth, and community banks do the lion's share of small-business lending. A strong capital ratio will reduce megabanks' incentives to trade instead of making loans. Over the long term, it will make these banks a more stable source of credit for the real economy and give them greater capacity to absorb unexpected losses. Bet on it, there will be future London Whale surprises, and the next one might not be so easy to harpoon.
Ms. Bair, the chairman of the Federal Deposit Insurance Corporation from 2006 to 2011, is the author of "Bull by the Horns: Fighting to Save Main Street From Wall Street and Wall Street From Itself" (Free Press, 2012).
Erskine Bowles, who is sort of a Democrat, met Wednesday with House Speaker John Boehner to help Republicans promote proposals to cut entitlements, as part of the “fiscal cliff” negotiations.
This is the right place for Bowles, who has long maintained a mutual-admiration society with House Budget Committee chairman Paul Ryan, R-Wisconsin. The former Clinton White House chief of staff has always been in the corporate conservative camp when it comes to debates about preserving Social Security, Medicare and Medicaid.
It’s good that he and Boehner have found one another. Let the
Republicans advocate for the cuts proposed by Bowles and his former
Wyoming Senator Alan Simpson, his Republican co-conductor on the train wreck that produced the so-called “Simpson-Bowles” deficit reduction plan.
After all, despite the media hype, Simpson-Bowles has always been a non-starter with the American people.
Last summer, at the Democratic and Republican national conventions,
so many nice things were said about the recommendations of the National
Commission on Fiscal Responsibility and Reform that had been chaired by
former Wyoming Senator Alan Simpson, a Republican, and Bowles that it
was hard to understand why they were implemented. Paul Ryan went so far
as to condemn President Obama for “doing nothing” to implement the
Simpson-Bowles plan—only to have it noted that Ryan rejected the
recommendations of the commission.
But, while a lot of politicians in both parties say a lot of nice
things about the austerity program proposed by Simpson-Bowles, there is a
reason why there was no rush before the election to embrace the
blueprint for cutting Social Security, Medicare and Medicaid while
imposing substantial new tax burdens on the middle class.
It’s a loser.
Before the November 6 election, Simpson and Bowles went out of their way to highlight the candidacies of politicians who supported their approach—New Hampshire Republican Congressman Charlie Bass, Rhode Island Republican US House candidate Brendan Doherty, Nebraska Democratic US Senate candidate Bob Kerrey. Bipartisan endorsements were made, statements were issued, headlines were grabbed and…
The Simpson-Bowles candidates all lost.
Americans are smart enough to recognize that Simpson-Bowles would stall growth. And they share the entirely rational view of economists like Paul Krugman.
“Simpson-Bowles is terrible,” argues Krugman, a Nobel Prize winner
for his economic scholarship. “It mucks around with taxes, but is
obsessed with lowering marginal rates despite a complete absence of
evidence that this is important. It offers nothing on Medicare that
isn’t already in the Affordable Care Act. And it raises the Social
Security retirement age because life expectancy has risen—completely
ignoring the fact that life expectancy has only gone up for the well-off
and well-educated, while stagnating or even declining among the people
who need the program most.”
On election night, Peter D. Hart Research Associates surveyed Americans with regard to key proposals from the commission. The reaction was uniformly negative.
By a 73-18 margin,
those polled said that protecting Medicare and Social Security from
benefit cuts is more important than bringing down the deficit.
By a 62-33 margin,
the voters who were surveyed said that making the wealthy start paying
their fair share of taxes is more important than reducing tax rates
across the board (62 percent to 33 percent).
But that’s just the beginning of an outline of opposition to the Simpson-Bowles approach.
To wit:
* 84 percent of those surveyed oppose reducing Social Security benefits;
* 68 percent oppose raising the Medicare eligibility age;
* 69 percent oppose reductions in Medicaid benefits;
* 64 percent support addressing the deficit by increasing taxes on
the rich—with more than half of those surveyed favoring the end of the
Bush tax cuts for those making more than $250,000.
Americans want a strong government that responds to human needs:
• 88 percent support allowing Medicare to negotiate with drug companies to lower costs;
• 70 percent favor continuing extended federal unemployment insurance;
• 64 percent support providing federal government funding to local governments;
• 72 percent say that corporations and wealthy individuals have too much influence on the political system.
AFL-CIO president Richard Trumka is right. On November 6, “The American people sent a clear message.”
With their votes, with their responses to exit polls, with every
signal they could send, the voters refused to buy the “fix” that Erskine
Bowles is selling.