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“Strengthening Global Capital: An Opportunity Not To Be Lost”

November 10, 2016 / Source: FDIC

Speeches & Testimony
November 9, 2016

Basel III is scheduled to be finalized by year-end and presented to top regulators and central bankers for approval in early 2017. The original goals of the six-year-long effort were to “reduce the complexity of the regulatory framework and improve comparability” and “address excessive variability in the capital requirements for credit risk.”1 These goals are laudable.
Unfortunately, as memory of the 2008 financial crisis has waned, the exercise has added a third objective: ensuring that the final calibration of the Basel III framework not significantly increase overall capital requirements.2 Should this occur, it would truly represent an opportunity lost. Instead of strengthening the foundation of the global financial system, as was intended with the original goals, Basel III would legitimize the inadequate status quo and undermine the long-run objective of real financial stability.
In my remarks today I will discuss key factors that are at the core of the on-going debate over what defines adequate capital. First, I will discuss the controversy over alternative measurements for judging adequate capital. Simply stated, most measurements are too complicated, set too low, and often vary by jurisdiction in ways that weaken global financial stability. Second, relying only on public information, I will note changes that the Basel Committee appears to be considering that will weaken current standards and why these changes are ill-advised. Third, I will reiterate my concerns regarding Total Loss-Absorbing Capacity (TLAC) and its use as a means to justify lower levels of capital and require firms to issue more debt.
Capital Adequacy
Capital levels are reported as a ratio, with equity capital amounts in the numerator and some measure of a firm's assets in the denominator. The simplest measure of capital, a leverage ratio, uses accounting equity (adjusted to remove intangible assets) and accounting assets. For decades, however, the Basel Committee has preferred a risk-based capital ratio, which uses a regulatory measure of capital and assets. Under this framework, regulators allowed certain debt instruments, with minimal equity-like characteristics, to be folded into the numerator, and for assets to be discounted by ever-lower risk weights in the denominator. These adjustments encouraged increased leverage among firms and were often amplified in certain jurisdictions.
During the 2008 financial crisis, markets quickly turned away from measuring bank stability with risk-based ratios and by necessity adopted the leverage ratio for its greater reliability and comparability across banks and jurisdictions. Adjusting leverage ratios to put firms on the same accounting standard quickly showed that while banks' risk-based capital ratios were often roughly equal, their leverage ratios often varied widely.
Today, the average leverage ratio for the world's largest banks is around 5.5 percent.3 This average conceals significant outliers in certain jurisdictions that have leverage ratios at pre-crisis levels of less than 4 percent, while they report risk-based capital ratios on par with the world’s strongest banks. Such inconsistency serves to undermine market confidence and financial stability, and is what the Basel Committee originally sought to fix.
One bank's recent and widely publicized experience serves to demonstrate the effects of such inconsistent standards. Its tier 1 risk-based capital ratio measured 14 percent, while its leverage ratio was 2.68 percent. It became evident that markets viewed the leverage ratio as the more credible measure of the bank's capital position, as counterparties fled at the first sign of trouble.4 For these reasons, the Basel Committee should not promise that there will be no significant increase in industry capital levels, and it would be a further mistake to enshrine such capital standards with a regulatory stamp of approval.

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