This week, hot-button legislation burned the wires. Little noticed was confirmation that new capital standards will more than double the cost of trading activities in banking organizations. These new rules are, though, a critical part of the big-bank break-up that’s well under way by the regulators, regardless of what Congress may do on the systemic-risk legislation. With earnings now heavily dependent on trading revenue, this capital regime – final in all but detail – is a critical strategic driver for diversified and non-traditional behemoths like Goldman Sachs, JPM-Chase and the like. The rules will also have immediate impact on broader capital markets, putting big speed-bumps on the road to resurgent asset securitization and similar ventures.
A short memo happily isn’t the place to parse the new trading-book rules. Suffice it to say that the new Basel standards are formidable. They take the 2005 final global market-risk standards and toughen them up in numerous respects, reflecting what regulators think they’ve learned from the intervening capital-market cataclysm. A major provision in the new rules imposes an “incremental-default” charge to capture the credit risk embedded in trading positions, striking at the heart of differences that in the past permitted canny bankers to arbitrage the living daylights out of the capital rules based on whether they booked an asset in the bank or an affiliated broker. The rules also whack the stuffing out of value-at-risk (VaR) models, forcing banks to factor risk based on a far wider range of market scenarios than the short-term, happy ones on which VaR once was calculated. The coup de grace comes with regard to securitization positions, especially complex ones, where regulatory capital goes way up even for obligations basking in AAAs from the ratings agencies.
Reflecting the scope of all of these changes, global regulators promised the industry to do a quantitative study before committing to the new regime. On Thursday, the Basel Committee released the study’s results, finding that trading-book capital would on average at least double under the new rules. This was, though, no surprise. Supporting a doubling in trading book regulatory capital, heads of state at the Pittsburgh G-20 summit late last month made more than clear that they saw this coming and wanted it to happen.
Why the press for punitive trading-book capital? Part of the reason lies in the lessons of the crisis, which showed that short-term scenarios and ratings-agency reliance left many banks naked to the storm. But, we think, there’s more at work here than just a push to bolster regulatory-capital reserves. We’ve been watching for a while each of the provisions in the Obama plan that dismantle the biggest banks piece by piece. Like the trading-book charge, none of these provisions tells banks what to do where or sets an arbitrary size limit. Instead, in a sophisticated and expert way, the new rules simply make it unprofitable to proceed as is. Each firm is thus left on its own to consider its options and restructure itself, accomplishing the underlying objective of all of the regulators to pry apart the very biggest banking organizations and get them back to basics.
That regulators have made up their minds on this point is evident not just from the high-profile statements at the G-20 and the seemingly-niggling details in the emerging regulatory regime. That Alan Greenspan endorsed it this week proves to us that it’s well under way. Mr. Greenspan is no fan of tough regulation nor in the past was he in any way fazed by financial colossi. He is, though, an expert reader of writing on the wall. When he supports breaking up big banks, it’s happening.