Capital Requirements Do More Harm Than Good

In a Bloomberg article out today, the situation of capital requirements imposed by a host of worldwide regulators is described in the following headings:

“Gray Area”

“Naïve Methodology”

“Gaming the System”


The article discusses how European banks are engaging in a practice known as “risk-weighted asset optimization” whereby banks game the regulatory framework using sophisticated models to establish their own desired risk weightings. It is rendering capital requirements and leverage ratios established by regulatory bodies such as the Basel Committee and the European Banking Authority not only useless, but harmful because the institution of such requirements provides false hope to investors fooled into thinking banks are adequately structured and solvent.

The newest of capital requirements established under Basel III and set to go into effect in 2019 establish banks’ core capital ratio to 9.5 percent of risk-weighted assets, but because core capital is not universally definable, and risk weightings are discretionary, nothing is accomplished save added confusion. Special Advisor to the Secretary-General on Financial Markets at the OECD, Adrian Blundell-Wignall points out that “as you move to Basel III, these issues will become more ubiquitous, not less. The core Tier 1 ratio is a ratio of two meaningless numbers, which itself is a meaningless number because banks can alter the ratio themselves. Basel III does absolutely nothing to address that.”

The timing of this article could not have been more perfect as it coincides with a speech given today by Fed Governor Daniel Tarullo on the evolution of capital regulation. Governor Tarullo discusses in a lengthy and relatively contradictory argument for the harmonization of international capital requirements regulation as being “the dominant prudential regulatory tool.”

He discusses along the way how every previous capital requirement regime failed and why. Some even as they are currently failing before their complete passage and installment, particularly Basel II, now the morphed Basel 2.5. Despite these rather pathetic and predictable shortcomings of prior failed regulation, he continues the quest for a more perfect regime in which such failings should be absent.

Why he believes that this time around capital requirements will not allow for regulatory arbitrage or encourage heightened, unwarranted risk-taking is a bit alarming. This is especially true of one particular requirement of new capital standards laid out in Dodd-Frank: the establishment of regular stress testing and capital planning.

By this, regulators hope to “make capital regulation more forward-looking by subtracting losses in asset values and earnings estimated to be sustained in an adverse macroeconomic scenario, in order to determine whether firms would have enough capital to remain viable financial intermediaries.” If they’re at all as foresighted as they were leading up to the last financial crisis, they might as well chalk this one up as a failure from the start.

Further setting up the new capital regulations for failure is the fact that U.S. capital requirements differ vastly from those set by international bodies.

From the speech:

“while U.S. bank regulatory agencies have published a proposed regulation for the new market risk capital requirements, we did not include the trading book securitization and resecuritization portions of Basel 2.5, which are supposed to take effect in 2011. The complication here, and with part of Basel III implementation, lies in the use of agency credit ratings. Dodd-Frank requires the removal of agency credit ratings from all regulations throughout the government. Thus, the banking agencies have had to develop substitutes for agency ratings in each of the quite different contexts in which they are used within the capital standards.”

Governor Tarullo’s speech demonstrates why regulators fair so poorly in their pursuit to institute capital requirements. Coming straight from the regulator’s mouth, it highlights just how naïve of a task it is to try to coordinate the establishment and enforcement of proper and efficient capital standards on a world’s stage. Regulators cannot possibly know where the next source of contagion will come from, nor from whom it will come, particularly when there exist such broad differences in their implementation, structure, and adoption. They merely enhance the element of systemic risk. Banks will continue to game the system allocating capital towards asset classes that satisfy arbitrary regulations rather than a soundly drawn-out risk assessment conducted by the actual players in the market.

James Groth is a research associate at Reason Foundation, a nonprofit think tank advancing free minds and free markets. Prior to joining Reason, where he works on monetary policy reform and financial regulation, he worked as a proprietary trader and asset manager. Groth holds a B.A. in economics from Tufts University.