Economics, Pethokoukis

Banks need to hold a lot more capital — the good stuff

Thomas Hoenig, vice-chairman of the Federal Deposit Insurance Corporation and former head of the Kansas City Fed, has been advocating a break up of America’s big banks. And I think that makes a lot of sense. But banks should also hold more capital. And as Hoenig explains in the FT, the various Basel standards do not provide for “enough real capital to absorb unexpected shocks to the economy.”

The Basel standards try to model the riskiness of assets when determining capital levels. “Using this system of risk-weighted assets,” Hoenig explains, “the 10 largest US banking groups had total Basel capital to risk-weighted assets averaging 11 per cent in 2007 at the start of the financial crisis. The chief executives of these banks were confident, even boastful, of being well capitalised.”

But by a more conservative standard that Hoenig favors, not so much. Hoenig:

Using tangible equity capital and total assets – a more conservative, more credible method of assessing capital adequacy – the average leverage ratio of those same US banks was only 2.8 per cent prior to the crisis, or less than three cents for every dollar of assets on the balance sheet. This more conservative calculation reflects what good analysts do: it excludes items that do not absorb losses in a crisis, such as goodwill, deferred tax assets and other intangibles. And it includes all assets, including those thought to be risk-free.

The ten largest US banks have an average tangible equity capital ratio of only 6.1%. Hoenig thinks that’s not nearly enough, noting that before deposit insurance was introduced, the TEC ratios for US banks of all sizes averaged above 10%. Without a government backstop, depositors insisted on high levels of sound capital. Now they don’t. But US taxpayers should, says Hoenig:

If the financial industry had had tangible equity capital approaching this level in 2008, we might still have had a crisis. But it would have been far less severe and far less costly to the public. Basel III’s implementation has been postponed, and that offers a real chance to get it right. If we do, we won’t need Basel IV.

Simpler banks holding more capital should be at the core of pro-market approaches to financial reform.

One thought on “Banks need to hold a lot more capital — the good stuff

  1. A lot depends on what you define as capital. The debt issued by governments that are bankrupt or the currency that is backed by those debts does not seem to make the grade. Time for gold to reenter the game once again.

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