Imagine if I told you I could reduce my own body weight by 80 per cent or more, on paper, through a series of calculations utilizing my own proprietary mathematical models, the details of which are so complex and highly prized that I couldn’t divulge them.
You would be right not to believe me, and might think I’m nuts. Yet this, in essence, is what regulators let banks do all the time with their balance sheets. Huge swaths of assets are allowed to vanish, making too-big-to-fail financial institutions seem leaner and safer than they are.
Under the system known as risk weighting, banks get away with this because they are allowed to stipulate that some assets carry little, if any, risk. Many government bonds, for instance, fall into the riskless category for purposes of determining regulatory-capital ratios. So a bank can assume it won’t incur losses on them, which allows it to keep a lower capital cushion. The flaw here is that rulemakers aren’t good at predicting what kinds of assets might blow up. Some governments, especially in Europe, are in awful shape and pose a real risk of defaulting.
In other words, the notion of risk weighting is a farce, at least the way it is practiced now. Yet it carries the imprimatur of the Basel Committee on Banking Supervision, the Swiss body that writes capital standards for most of the developed world. Thankfully, a US regulator has stepped up to say the world should scrap the Basel committee’s standards.
Speaking out
The American speaking out against the latest Basel proposal is Thomas Hoenig, the former head of the Federal Reserve Bank of Kansas City who now sits on the Federal Deposit Insurance Corp.’s board. And to see why he is right to do so, take a look at Germany’s largest bank, Deutsche Bank AG.
Deutsche Bank had $2.84 trillion of assets on its June 30 balance sheet, which was prepared using the International Accounting Standards Board’s rules. Yet the company said it had only 372.6 billion euros of risk-weighted assets. That’s the figure it used to come up with a 10.2 per cent capital ratio for regulatory purposes.
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So, somehow Deutsche Bank made 83 per cent of its assets disappear, which really is all you need to know to realize that the whole Basel construct is a sham. More than three-quarters of Deutsche Bank’s total assets consist of securities, loans and derivative instruments, all of them carrying varying degrees of risk. Yet the much smaller risk-weighted figure would have us believe that the bulk of Deutsche Bank’s assets were riskless, which obviously can’t be true.
There’s no way to tell from the company’s latest report to investors how Deutsche Bank got this figure, except we know some asset classes, such as sovereign debt, are deemed much less risky by Basel rules than other kinds of assets, such as plain- vanilla loans. The Basel rules let the largest banks rely on their own proprietary models to determine how risky their assets are. The latest revisions proposed by the Basel committee, which span several hundred pages, wouldn’t change that.
In a September 14 speech, Hoenig said the better way to assess capital adequacy is to develop a rule that is simple and enforceable. “It should reflect the firm’s ability to absorb loss in good times and in crisis,” he said.
“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.” And it “should result in a bank having capital that approximates what the market would require” if no government safety net were in place, Hoenig said.
Capital ratios
The measure that best achieves those goals, he said, is a capital ratio that divides a bank’s tangible equity by tangible assets. Tangible equity would start with shareholder equity and exclude all intangible assets (such as goodwill), which are worthless in a crisis. Hoenig also would exclude deferred tax assets; profitable companies can use these to reduce their tax bills, but they are worthless to companies going broke. Hoenig said a reasonable capital ratio would be 10 per cent or higher, depending on examiners’ findings at a given bank.
Deutsche Bank would look much weaker by this measure, mainly because the assets in the calculation would be about six times as large. Its capital ratio under Hoenig’s formula would be 1.4 per cent. That translates into leverage of about 70-to-1.
Because of differences in how derivatives are treated under international accounting standards, Deutsche Bank’s reported assets probably would drop by about half if the bank used US generally accepted accounting principles. Likewise, its capital ratio under Hoenig’s way would be higher using US GAAP numbers, but nowhere near 10 per cent.
Hoenig’s proposal has weak spots. Arguably, a 10 per cent minimum isn’t high enough. And the contents of banks’ assets and liabilities wouldn’t be any more transparent than they are now. US banking regulators, including the FDIC and the Federal Reserve, are in the process of adopting their version of the latest Basel proposals, known as Basel III.
At least under Hoenig’s idea we would move away from a system that is designed to breed excessive leverage. And we would get regulators out of the business of guessing which assets are safe and which aren’t. It’s worth a shot.
Jonathan Weil is a Bloomberg View columnist. The opinions expressed are his own