Last week, I urged the Basel Committee to abandon what I call wish-fulfilment quantitative analysis if it wants, as it should, finally to integrate the global rulebook. Numbers such as how much capital all of the banks in all of the world may hold are nice to have, but of virtually no use in assessing real-world impact. This week, we’ll turn to how misguided U.S. regulators are as they continue their simple, sum-it-up impact methodology. Why in heaven’s name would regional banks want all the tailoring in the new proposals or community banks hanker for a leverage ratio if they didn’t think it would make a meaningful difference in what matters most to them: profitability? Yet, the U.S. agencies have somehow concluded that these two sweeping proposal will make virtually no difference to safety and soundness because bottom-line capital totals would be virtually unchanged. But, what matters is not how much capital an industry sector has in aggregate, but how much capital each banks puts aside for its own risk and, then, whether it’s too much for profit, too little for safety, or somewhere between these two extremes and thus just about right.
The community-bank leverage ratio (CBLR) does what Congress instructed the agencies and then some. Banking organizations with less than $10 billion in assets that meet certain eligibility criteria are released from obeisance to the risk-based capital (RBC) rules and instead put under a new leverage regime of a flat nine percent ratio regardless of risk. The agencies like this approach – or so they say now that they have to implement it – because overall community-bank capital numbers don’t change much. Unsaid in the proposal is what this new approach allows for any community bank without a strong will to live or a surprisingly assertive examiner.
The whole construct of risk-based and leverage capital is that the risk-blind leverage ratio (LR) is a backstop. Unless one sets the LR far above the risk-based ratio, the bottom-line incentives that drive each bank are to take as much risk as possible above the simple leverage ratio to make as much money as possible. When the leverage ratio is a bank’s binding constraint and above its RBC requirements, it creates a strong incentive for risk-taking – we’ve said it in our assessment of the LR. More importantly, the banking agencies said it in their proposed changes to the enhanced supplementary leverage ratio, in which they belatedly sought to recalibrate the big-bank capital balance to restore the primacy of stressed risk weightings to realign risk and profit incentives.
Why does an LR-only regime make sense for community banks and have perverse results for big banks? The CBLR proposal is mum about incentives, taking comfort in aggregate totals showing that overall community-bank capital won’t change much and citing all the burden relief these banks will get. Burden relief is for sure and all to the good, but will community banks keep these totals and also leave risk allocation as is? Would any sensible bank keep a large book of low-risk assets once a punitive nine percent leverage ratio applies to them? Of course not.
As a result, the CBLR ensures that community banks will shift their books of zero-weighted government obligations into higher-risk loans. Some of these loans will do wonders for under-served borrowers such as first-time homeowners and start-up small businesses. But, community banks may well bulk up their holdings of high-volatility commercial real estate, collateralized loan obligations, and all sorts of other high-risk stuff for which a nine percent ratio is more than insufficient. Indeed, at least with regard to commercial real estate lending, this appears to be the plan for some community banks as soon as they get the LR all-clear.
Under the risk-based rules, banks generally have to hold at least a ten percent total ratio, and that’s after taking all the zero-weighted stuff and a far more stringent definition of capital into account. The proposed nine percent ratio is in fact a sizeable discount from the current risk-based rules for higher-risk assets – a fact sure to show as banks keep their totals the same but start to take a lot more credit risk.
The only way to understand what a regulatory proposal does to a bank is not to do simple sums, but to follow the money to see how incentives change and then what the new incentives do to bank safety and soundness on an individual and industry basis. The way to anticipate financial-stability risk is then to see what banks as a sector are likely to do and determine how competitors will answer the new banking market. The best way to anticipate social-welfare and equality effects is to consider prudential and stability results to see if equality-enhancing credit remains on offer and how much more or less likely a financial crisis may be.
The reason banks want all the changes they seek is because post-crisis rules to date omitted any such balanced cost-benefit analytics; the reason I fear we may rue these corrections to post-crisis rules is that regulators still haven’t learned to do them.