The industry is in for a major regulatory overhaul, and one area that's getting lots of attention is capital ratios. The conventional argument goes something like this: the failure or forced sale of so many banks indicates that Tier-1 capital reserves were not adequate. More capital would have prevented intervention.

Not all believe the issue is so cut and dried, however. The banking industry operates on confidence much more than some policy makers might care to admit. John Douglas, a partner at Paul Hastings, Janofsky & Walker and general counsel to the Federal Deposit Insurance Corp. during the S&L crisis, points out that many banks that ran aground in 2008 had capital ratios well above the required minimum set by regulators; had their capital ratios been a few percentage points higher it's unlikely they could have weathered the evaporating market confidence.

Consider that Washington Mutual had a Tier-1 capital ratio of 8.4 percent on September 30, well above the 6 percent threshold that regulators use to classify a bank as well capitalized. JPMorgan Chase, which purchased Wamu had a similar ratio of 8.9 percent. Wachovia, which agreed to sell to Wells Fargo in October, had a capital ratio of 7.5 percent as of September 30, compared to Wells Fargo's 8.6 percent. And National City had an 11 percent capital ratio, and yet had to sell out to PNC Financial Services. By comparison, Bank of America, considered one of the bedrock financial institutions, had a capital ratio at the end of the third quarter of 7.6 percent.

These numbers show that capital ratios are not a certainty in measuring health, and imposing a blanket increase will not instantly stabilize financial institutions. In fact, much of banks' recent troubles involved liquidity. As the industry has learned, banks can have high capital ratios at the same time that funding sources dry up. Thus, Paul Miller, an analyst at FBR Capital Markets, says banks should hold capital based on the risk that a funding source could dry up on short notice. This might encourage banks to increase more stable funding, easing liquidity concerns.

"To make sure the current financial environment is not repeated, the government must regulate the assets and how the assets are funded, rather than provide different levels of regulations for different types of financial entities," Miller writes in a recent research report. "A big issue was the amount of short-term funding that was used by the largest financial firms to fund illiquid assets. Assets that are funded by more traditional means, such as deposits and other long-term funding sources, could be leveraged 15x (holding roughly 6% capital), while assets funded through short-term sources should be leveraged less, somewhere between 6x and 7x (holding roughly 15 percent to 20 percent capital). Regardless of the banking charter, any holder of assets that relies heavily on short-term funding should be considered a structured finance company and should be held to higher capital standards."

Meanwhile, Douglas suggests that lawmakers give regulators more discretion in evaluating the real economic strength of an institution, without enacting statutes that require a regulatory response that might force banks into unwise asset sales. But the pendulum in Washington is swinging toward more regulation. And lawmakers probably won't be inclined to give regulators more discretion.

As the market has lost confidence in banks, so too have lawmakers lost confidence in regulators. Confidence, as much as capital, must be rebuilt, and it may take longer.

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