WORD ON THE STREET: I have been involved in central banking and financial supervision my entire career. I understand the importance of having the right market conditions and regulatory framework for an economic system to thrive. And most certainly I know that the foundation of a strong financial system is strong capital.
For these reasons I wish to add my perspective regarding Basel III. After reading the entire 1,000-plus page proposal, I would encourage the Basel Committee and the international regulatory community to step back and rethink the Basel capital standards.
Basel III is intended to be a significant improvement over earlier rules. It does attempt to increase capital, but it does so using highly complex modeling tools that rely on a set of subjective, simplifying assumptions to align a firm's capital and risk profiles. This promises precision far beyond what can be achieved for a system as complex and varied as that of U.S. banking. It relies on central planners' determination of risks, which creates its own adverse incentives for banks making asset choices.
The poor record of Basel I, II and II.5 is that of a system fundamentally flawed. Basel III is a continuation of these efforts, but with more complexity. It also is more prolific since it applies across all banking firms. Directors and managers will have a steep learning curve as they attempt to implement these expanded rules. They will delegate the task of compliance to technical experts, and the most brazen and connected banks with the smartest experts will game the system.Â
In private discussions, I find a good deal of uneasiness about Basel III's ability to be more effective than previous Basel efforts; however, there is a sense that we cannot go back. I suggest that we not only can go back – we must. In my remarks to follow, I will set out my views on the role of capital and the flaws of Basel III, and then will suggest a simpler alternative that takes us back to the basics.
Capital, the safety net and markets
Capital is the foundation on which a bank's balance sheet is built. There can be no fortress balance sheet without fortress capital. In a market economy, capital insulates a firm from unexpected shifts in risk and from losses on loans and investments gone bad. A reliable capital measure facilitates the public's and the market's understanding and judgment of the financial condition of a firm and industry.Â
And finally, while essential to the health of a firm, capital has its limits. Even high levels of capital cannot save a firm from bad management or save an industry from the cumulative effects of excessive risk taking.
In judging the role of capital, it is useful to look back at bank capital levels in the U.S. before the presence of our modern safety net. Prior to the founding of the Federal Reserve System in 1913 and the Federal Deposit Insurance Corp. (FDIC) in 1933, bank equity levels were primarily market driven. In this period, the U.S. banking industry's ratio of tangible equity to assets ranged between 13% and 16%, regardless of bank size. Without any internationally dictated standard or any arcane weighting process, markets and the public required what would seem today to be excessively high capital levels.
With the introduction and expansion of the safety net of deposit insurance, central bank loans and ultimately taxpayer support, the market's capital demands changed. While the safety net protects depositors from loss and promotes stability in the system, its secondary effect has been to erode the market's role in disciplining banks. Depositors and other creditors have come to understand that the safety net protects them far more importantly than does bank capital or good management.
It is important to ask where these changes have taken us. One of the most significant results has been that bank supervisors, rather than the market have been left the difficult task of determining adequate capital for the industry. Unfortunately this has led to a systematic decline in bank capital levels.
Between 1999 and 2007, for example, the industry's tangible equity to tangible asset ratio declined from 5.2% to 3.8%, and for the 10 largest banking firms, it was only 2.8% in 2007. More incredible still is the fact that these 10 largest firms' total risk-based capital ratio remained relatively high at around 11%, achieved by shrinking assets using ever more favorable risk weights to adjust the regulatory balance sheet.
It is no coincidence that the financial industry in 2008 was unable to withstand the pressures of a declining market, nor bear anywhere near the losses that the taxpayer eventually assumed. It turns out that the Basel capital rules protected no one – not the banks, not the public and certainly not the FDIC that bore the cost of the failures or the taxpayers who funded the bailouts. The complex Basel rules hurt, rather than helped the process of measurement and the clarity of information.
Basel III introduces a leverage ratio and raises the minimum risk-weighted capital ratios, but it does so using highly arcane formulas, suggesting more insight and accuracy than can possibly be achieved. Where the markets assess, demand and adjust intrinsic risk weights on a daily basis, regulators using Basel look backward and never catch up.Â
For example, people knew well in advance of the recent financial crisis that the risk on home mortgages had increased during the period between 2005 and 2007, yet no changes were made to the risk weights. Basel III still looks backward, as demonstrated by the few changes made regarding the weights assigned to sovereign debt.
It is noteworthy to observe how much the industry's capital level diverges, depending on which Basel measure is reported. For the 10 largest U.S. banking organizations as of the second quarter of 2012, total Tier I equity capital was $1.062 trillion. Total adjusted tangible equity capital was $606 billion. In a crisis, which number counts?
Given the questionable performance of past Basel capital standards and the complexities introduced in Basel III, the supervisory authorities need to rethink how capital standards are set. Starting over is difficult when so much has been committed to the current proposal.
An alternative to Basel
How might we better assess capital adequacy? Experience suggests that to be useful, a capital rule must be simple, understandable and enforceable. It should reflect the firm's ability to absorb loss in good times and in crisis. It should be one that the public and shareholders can understand, that directors can monitor, that management cannot easily game and that bank supervisors can enforce.
An effective capital rule should result in a bank having capital that approximates what the market would require without the safety net in place. The measure that best achieves these goals is what I have been calling the tangible equity to tangible assets ratio.
Tangible equity is simply equity without add-ons such as good will, minority interests, deferred taxes or other accounting entries that disappear in a crisis. This tangible capital measure does not remove the complexities from the balance sheet. It does not attempt to differentiate risks among assets. It does not tier the measure into any number of refined levels. There is no governmental ex-ante endorsement of risk assets or capital allocations.
Instead, this tangible capital measure is a demanding minimum capital requirement within which management must allocate resources within the overall capital constraint.  This simple measure accepts that firms quickly shift their allocation of assets to take advantage of changing risks and rewards.
This simpler but fundamentally stronger measure reflects in clear terms the losses that a bank can absorb before it fails, and regardless of how risks shift. It provides a consistent and comparable measure across firms.
Since the federal safety net is the current substitute for capital in protecting the depositor, it also is reasonable that the supervisor should expect the same minimum capital as would the market without the safety net. As noted earlier, the equity ratio for the banking industry before the safety net was implemented ran between 13% and 16%. Therefore, the starting point for any discussion of an acceptable level of tangible equity for all banking firms should be well above the 3.25% level now implied by the Basel III proposal.
Finally, under this simpler approach there remains the challenge of more precisely assessing individual institutional risk and judging whether this minimum capital is adequate. That judgment should be determined through the periodic examination process, which, for the largest banks, has become de-emphasized in favor of stress tests. It is the often-ignored Pillar II of the Basel standards.
This is no simple task. However, it is through this process, properly conducted, that supervisors can best assess a financial firm's fundamental operations, liquidity, asset quality and risk controls.
Thomas A. Hoenig is a director of the Federal Deposit Insurance Corp. This article is adapted and edited from a recent speech. The original text is available online.
