Eugene Ludwig

The financial crisis of 2007 to 2009 has taught the financial world, including regulators, many powerful lessons. The post-crisis period that we are entering offers an opportunity to put those lessons to good use. However, there is a genuine danger of going too far in one direction or the other. It is essential to strike a balance between the private sector's need to operate and innovate without needless regulatory burden, with the need to establish strong prudential regulatory controls.

Among the key areas that will receive increased regulatory focus are: governance, including board-reporting mechanisms; risk identification, including systems integration so that risks can be identified in real time; stress testing; liquidity management; and capital. Of these, much of the focus at the moment is on capital, and in this area, as much as any other, there is tremendous danger if the legislative and regulatory bodies go overboard.

Leverage Ratios Are Back

It has been proposed that the Basel II framework be changed so that banking organisations will be subject to higher minimum capital levels and leverage ratios. At the time of writing, the Basel Committee on Banking Supervision was meeting to finalise the specific proposed level of the leverage ratio and other capital proposals. One thing is clear: required capital is going to increase. The cumulative effect of a new leverage ratio, stricter definitions regarding eligible Tier 1 capital, counter-cyclical capital buffers, increased market risk requirements and whatever else comes down the pike - such as supplementary requirements for large institutions - will push minimum required capital levels higher. Even for US banks, which are already subject to a leverage ratio, it is likely the cumulative effect of the proposals will be significant.

Adding leverage ratios may seem warranted, but doing so flies in the face of the original Basel II concept, which was to avoid hard-wired leverage ratios. The logic went that leverage ratios tend to spur banking organisations to take more risks to boost profitability under the leverage umbrella - rather than engage in less profitable, but more stable, balance-sheet businesses. This problem is no doubt exacerbated by the fact that the cumulative effect of the proposed new requirements will be so high. These requirements, taken together, are sufficiently high enough to provoke concern. Firms may take greater risks to earn a high return in some businesses, in order to show the robust overall firm earnings that help companies attract capital.

Devil in the Detail

Some of the criticism of the proposed elevated requirements, and particularly the leverage ratios, is that they give insufficient credit for some attributes that clearly mitigate risks. For example, a bank that has strong core deposits would be required to have the same capital ratios as a bank that does not. Similarly, Basel does not differentiate in terms of ratios between banks with concentrated loan books or poorer collateral characteristics and those with better books of business. A similar concern can be raised by banks that carry a strong allowance for loan losses versus those that do not.

Supervisors do have the latitude to apply even tougher standards than the Basel II ratios where the supervisor believes they are warranted. However, this does not fix the problem for banks, which given their overall risk profile, may be able to make a convincing case that they are overcapitalised.

One cited virtue of a leverage ratio is that it is supposedly simple - a tool like a western sheriff's six-shooter that applies rough justice. In fact, leverage ratios are never that simple. First, there is the important issue of what to count as capital - preferred instruments? Convertible instruments? Deferred tax assets? Capital investments such as software? Basel II originally took a tough stance, counting essentially only permanent shareholders' equity as high quality and acceptable Tier 1 capital. However, this definition came under pressure due to developing market practices as well as differing tax and legal frameworks, and was eventually modified to include a limited amount of hybrid securities, under certain restrictive conditions.

The denominator of a leverage ratio can be equally complicated. Basel II's leverage ratios are expected to deviate from total assets and include some measure of off-balance-sheet exposures. Accordingly, valuations for traded positions and other more complicated structured products, as well as categories of loans and securities, will be of considerable importance.

Ironically, these exposures include one of the most problematic aspects of Basel II in terms of spurring the financial crisis - securitisations, the risk weight of which are now widely regarded as too low and one of the first post-crisis 'fixes' made to the framework. It is tricky business, getting the ratios right, particularly when the innovative marketplace is waiting to design around the definitions.

The Maginot Line

Some critics have said that the proposed Basel II standards are a kind of Maginot Line - they might have worked in the last financial crisis but they are not needed now. As a former supervisor, I would not go that far. Establishing some leverage ratio floors is helpful to control outliers.

However, I consider it counterproductive to 'pile on' new capital ratios and requirements while disregarding risk-mitigating factors put in place by banks, such as strong core-deposit ratios or other liquidity enhancing mechanisms.

Another worry is the fact that the proposed ratios will apply to banking organisations but not to non-bank financial firms. At the moment, the shadow regulatory system is alive and well and it will, over time, take advantage of the fact that banking organisations are subject to stricter capital regimes.

Should Capital Be King?

I have heard it said in Washington that all you need to know about prudential supervision is covered by three rules: "Capital, capital and more capital." Any good supervisor knows this is not the case. Capital should not be the king of good supervision, but merely one of the important barons in a regime of effective prudential rules. Capital is vital, to be sure. However, too much capital can also be counterproductive, and most seasoned regulators would focus somewhat less on capital and more on management, liquidity and asset quality.

Indeed, a careful review of the past crisis suggests that these other factors correlate more tightly with success or failure than capital levels per se.

Through the Cycle

One final caution: right now through-the-cycle provisioning and capital charges are all the rage, particularly given the successful example of Spain. However, I am not convinced that in other countries the supervisors or the markets will allow banks to take down capital levels in a crisis. One never knows how deep a crisis will be. We certainly did not know this time. I believe that in the US, at least, there will be an extreme reluctance to allow banks to reduce capital in the middle of a crisis. Rather, all the pressures will push in the direction of taking capital levels even higher.

Strong medicine must be prescribed carefully to suit the patient and the disease. The better calibrated the dosage, the more effectively it works without causing toxic side effects. No sensible financial person, certainly not a former regulator like me, would argue against prudent capital floors for all and higher levels for some banks. However, there is a danger of going too far with proposed capital levels, and for some banking organisations the side effects may outweigh the benefits of the medicine. More prudence may well be necessary to make this set of prudential proposals effective.

Eugene Ludwig is the founder and CEO of Promontory Financial Group and was the US comptroller of currency between 1993 and 1998