Presently, the major issue relating to banks surrounds the question of capital requirements. Late last year, international banking negotiations known as "Basel III" adopted a guideline to require banks to hold capital (equity and retained earnings) in an amount of at least 7% of risk-weighted assets. Technically, the figure is 4.5%, with a 2.5% buffer during periods of "excess credit growth." Below those thresholds, banks would be required to raise more capital, with regulators expected to exercise resolution authority if bank capital dropped below 4% of assets.
The discussion now is about the additional margin-of-safety that large systemically-important banks should be required to hold - the likely figure being about 3% - which would put the total capital requirement as high as 10% of risk-weighted assets, for major banks during periods of rapid credit growth. That would still allow these banks a 10-to-1 leverage ratio - which given the range of default rates on various classes of bank debt, is appropriate, and not unreasonably restrictive. That's especially true because debt created at points of rapid credit growth is often of fairly low-quality, as we saw in the aftermath of the housing bubble. Lehman and Bear Stearns ran leverage ratios near 30, with disastrous results. Fannie and Freddie's leverage multiples were even higher, at about 40. You might recall that Long-Term Capital Management also ran at a leverage multiple of about 40-to-1 before it imploded. It's probably worth noting that according to the Fed's consolidated balance sheet as of June 8, Ben Bernanke has now taken the Federal Reserve's leverage ratio to 53.4. Fortunately or unfortunately, U.S. taxpayers would automatically end up subsidizing any Fed losses, so unlike commercial banks, the Fed could actually go insolvent without major consequences.
After significant price weakness, the banks advanced late Friday when CNBC suggested - without any identified source - that the additional capital buffer for major banks might end up being closer to 2-2.5%. A lower capital cushion would put the allowable leverage ratio at about 11 in periods of rapid credit growth and as high as 15 otherwise. Undoubtedly, part of the pressure to ease the requirements is due to the fact that bank stocks have been declining. It's ironic that the proposals most likely to boost bank stocks are those that would make the banking system more systemically vulnerable and more likely to require government bailouts. But that's essentially how option pricing works. If your downside risk is covered, higher volatility actually increases the value of the option. For our part, we're 100% behind FDIC head Sheila Bair - "On obvious things like higher capital standards, I say full speed ahead and the higher the better."
Clearly, there are intense efforts underway to reduce the requirement for banks to carry more capital, and the FASB has now effectively abandoned even modified versions of mark-to-market, which could have included reasonable approaches such as 3-year averaging. From our perspective, the problem in the economy is not that banks are over-regulated, but that they are quietly holding a large amount of non-performing assets, and remain unlikely to expand their risk portfolio further. Either we subsidize these assets for years through interest rate spreads that are hostile to depositors, small savers and the elderly, or we initiate approaches to allow the existing debts - particularly mortgages - to be reasonably restructured. Policy makers seem to be on a fairly strong course in favor of the first option - essentially allowing a zombie banking system like Japan's. It's a choice, but it comes with the consequence of anemic economic prospects.