WASHINGTON - Policymakers are pushing past the increasingly complex calculations of capital to find new and better ways to measure a bank's health.
One suggestion comes from Arturo Estrella, vice president of financial markets and institutions at the Federal Reserve Bank of New York.
In the July issue of Economic Policy Review, Mr. Estrella advocates simplifying minimum capital standards while allowing banks to use internal risk-management models to determine how much capital they should hold.
Mr. Estrella joins scores of commentators offering ways for regulators to adapt capital standards to a changing financial services environment.
Institutions hold capital to reduce taxpayers' exposure to bank failures, and to improve their credit ratings. Regulators currently require banks to hold at least 4% capital. Most banks hold at least 6%.
While regulators want well-capitalized banks, they are concerned that banks are holding too much capital to ensure they are comfortably above the minimum standards. Besides being an inefficient use of capital, it depresses profits and constrains lending.
The current trend to make capital standards more complex will only exacerbate this problem, according to Mr. Estrella. For example, the Fed in June proposed adding interest rate risk to risk-based capital standards, which would make it even tougher to calculate a bank's ratios.
Mr. Estrella's solution: Keep it simple. Regulators should focus on the internal models banks use to identify their ideal capital levels and make the minimal capital requirement a simple ratio that can identify sick banks. This would preserve the dual system currently in place, he said.
Mr. Estrella said his long-term plan could produce the same safety and soundness benefits at a lower compliance cost and without constant regulatory oversight.
Under his plan, the bank's internal capital calculation would become binding. "The banks would have to come up with the most precise measure they can develop," he said. "If a bank determines with its model that it needs 8%, then it must be 8%."
Bankers, however, would still calculate a simple minimal capital requirement. "We wouldn't go much beyond what we have now," he said. "In some ways, we might even be able to simplify."
Regulators would ensure that banks meet the levels set by the internal models, he said. Also, they would verify that the models work properly.
Examiners would know a bank is in trouble when capital falls from the internal model rate toward the minimum capital rate. This fall would trigger regulatory intervention, he said.
"The conflict between simplicity and accuracy is solved," Mr. Estrella said. "You have one that is simple and serves limited purposes, and you have one that is accurate that banks come up with."
Banking industry observers said Mr. Estrella is on track.
"He recognizes that the role of a regulator is to create a system that generates red flags when there is cause for concern from the standpoint of capital," said Mike ter Maat, an economist at the American Bankers Association. "The role of the regulator is not to opine on what each institution's efficient level of capital ought to be."
Karen Shaw Petrou, president of industry consulting firm ISD/Shaw Inc., said Mr. Estrella's plan closely resembles the capital system the securities industry employs.
"That would become competitively advantageous as banks move into nonbanking," she said.
Ms. Petrou also said Mr. Estrella's plan would benefit bankers because they no longer would constantly be adjusting to a new way of calculating capital standards.
"It will avoid the inevitable thrust toward increasingly iterative capital standards," she said. "That is to the industry's long-term advantage."