Today, Bloomberg confirmed the forecast FedFin has provided to you over the past few weeks: look out for leverage. Buttressed by an increasingly large chorus of risk-based doubters at the Federal Reserve, the FDIC has persuaded it to join a campaign to corner the Comptroller and force a new, tough U.S. leverage standard. This may come in concert with the U.S. final Basel III rules as early as next week. More likely, leverage will come later. But, it’s surely coming at far higher levels than most big banks have long thought possible. And, later might well be sooner – markets have a habit of demanding immediate compliance once they see the rules. Now, though, is a particularly tricky time to tell big banks to top up their reserves.
Why? Failing to balance new capital demands – even if only in proposed form – with current market realities could create a new doom loop – banks called upon to hike capital when markets are so volatile that current capital is drained, undermining credit availability and disrupting markets still more to start the adverse feedback loop all over again.
This week, we’ve seen three systemic-scale crises roil global banking. First is the contagion effect of the decision by China’s central bank to cut off inter-bank liquidity in an effort to strangle shadow banks. A worthy goal, but way too late and coming at high cost not just in China, but across the globe. Second is continuing chaos in the Eurozone. Some days inter-bank credit flows, some days, it doesn’t except at high cost to struggling banks that still pose gigantic risk to sovereigns in the still-dangerous “doom loop” that characterizes the Continent.
And, back home, there’s the FRB’s decision to taper. Mr. Bernanke tried to comfort markets by assuring them this isn’t for sure and it won’t come fast, but they didn’t care –
trading as always on future profits, not current conditions, investors fled fixed-income markets.
Where does this chaos now hit capital demands to come? Key to understanding how much capital is required comes from a look at both the numerator and denominator. I think I know the numerator – capital will have principally to be tangible common equity which means that lots on big-bank balance sheets now won’t count.
The denominator is a lot trickier. First, does it filter unrealized gains and losses? Basel III says no, as did the pending U.S. proposal, although the latter contemplated some major exemptions for benchmark fixed-income holdings that could cushion current market volatility if included in the final rule. Second, is the denominator based on GAAP or IFRS? The latter – the approach recommended by FDIC Vice Chair Hoenig and the Brown-Vitter bill – grosses up loads of off-balance sheet exposures on grounds that netting doesn’t always work and banks could thus get stuck with lots more risk. This is a debatable presumption, but incontrovertibly it’s a very costly alternative. If adopted in the U.S. rules, banks that now think themselves well insulated even from higher leverage rules and a G-SIB surcharge would be suddenly under-capitalized.
Leverage – even lots more of it – might well make sense. But now? China’s overdue decision to discipline risky banking comes at the worst possible moment. Instead of imposing discipline, the sudden shut-off of the liquidity spigot is sowing systemic risk. The U.S. leverage rule could have a similarly systemic effect. A slam-down on leverage will lead to a shut-off of bank financial intermediation. Who’ll step in? The shadows, of course. Funny how well-intentioned rules have unintended consequences.