The 1988 Basel accord was designed to modernize capital standards and level the playing field in international bank competition.
But U.S. banks are being forced to adhere to a much higher standard, which could limit their competitiveness and hamper their lending ability.
This standard, called the leverage ratio, has been pushed so hard by the U.S. lawmakers and regulators that it has effectively displaced the risk-based rules of the Basel accord.
Under risk-based rules, capital requirements are governed by portfolio composition. The higher the level of asset risk, the higher the capital requirement.
But U.S. officials are insisting that U.S. banks also conform with leverage standards that set minimum ratios of tangible common equity to average tangible assets, regardless of the riskiness of those assets.
Making It Official
A 5% leverage ratio has been a de facto standard for several years. It recently was made an explicit benchmark of bank health by the Federal Deposit Insurance Corp.
The implications are profound.
"Rising U.S. leverage requirements are emasculating the purpose of having worldwide capital standards," warned Robert L. Clarke, former comptroller of the currency.
The trend has "stark implications for the availability of credit," he said.
To appreciate how U.S. leverage standards have subverted the intent of risk-based rules, look no further than Citicorp, the nation's biggest banking company. It is aggressively shedding assets and raising capital to boost its leverage ratio above the current 4.1%.
Meanwhile, $460 billion-asset Dai-Ichi Kangyo Bank Ltd., Tokyo, is comfortably operating with a 3% leverage ratio. In London, $250 billion-asset Barclays Bank PLC is cruising along with a 4.2% ratio. And Frankfurt-based Commerzbank, with $140 billion in assets, is operating with a 2.9% ratio.
"Certainly the U.S. leverage standards are tougher than what we've seen domestically for a long time, and tougher than what we've seen in other parts of the world," said Gregory Root, an analyst with Thomson Bank-Watch, an American Banker affiliate.
Leverage standards began their trek to dominance after passage of the 1989 thrift reform law. In response to the minimum 3% to 5% leverage range specified by regulators, U.S. banks quickly adopted 5% as the base, according to Herbert Baer, a senior economist at the Federal Reserve Bank of Chicago.
In fact, he said, it appears that many banks are aiming for 7% so as to clearly distance themselves from the perceived taint of being anywhere near federal minimums.
At first glance, the 5% leverage capital ratio would not seem a major problem for U.S. banks. The nation's banks at yearend held $219.13 billion of Tier 1 capital, equaling a solid 6.6% of average tangible assets, according to Ferguson & Co., a consulting firm based in Irving, Tex.
But Ferguson analysts discovered a chasm between the haves and the have-nots in terms of capital. At yearend, 483 U.S. banks, together controlling $964.9 billion of average tangible assets during the fourth quarter, fell below the 5% leverage threshold.
Drastic Steps Required
To meet 5%, American Banker calculates, these 483 banks needed $5.4 billion of additional capital at yearend or would have had to reduce average fourth-quarter assets by $107.3 billion.
To reach 6%, the banks needed roughly $15 billion of additional capital - or would have had to shed a stunning $250 billion of average assets.
For the many banks having trouble raising capital, shrinking is the only feasible course.
This "certainly is part of the explanation for the credit crunch and may well have something to do with the slow pace of the economic recovery," said Stuart Greenbaum, head of banking research at Northwestern University, Evanston, Ill.
Evidence of the leverage ratio's dominance is set forth in a study prepared by Mr. Baer and Chicago Fed associate economist John N. McElravey.
Changes in Tier 1 risk-adjusted capital ratios from mid-1989 through last September seem to explain only 12% of changes in asset size at the nation's 127 largest bank holding companies. By contrast, changes in leverage ratios appear to explain 42% of changes in total assets.
Pros and Cons
Though foreseeing that U.S. banks in the short term will be somewhat handicapped, Mr. Root said he believes they will eventually gain a competitive advantage from their capital-raising efforts.
That is cold comfort to a top New England bank regulator, who says leverage minimums are forcing damaging contractions at some of the already-weak banks in his district.
Richard Syron, president of the Federal Reserve Bank of Boston, complained at a recent conference sponsored by the Federal Reserve Bank of Chicago that banks in the Northeast are selling some of their better loans to shrink into compliance with leverage requirements - emerging compliant but weaker for having done so.
"You end up leaving the FDIC with a weaker book of business." Mr. Syron charged.
What drove Congress to emphasize the leverage ratio was a bank deposit insurance fund crisis that came hard on the heels of a thrift deposit fund disaster.
"As soon as the first tax dollar went to the Federal Savings and Loan Insurance Corp., the definition of capital changed," said Mr. Syron. "It became co-insurance."
In that light, the leverage ratio makes sense, said James Sexton, the former director of bank supervision at the FDIC.
"Regulators don't care much about the risk-adjusted ratio, because it weights capital requirements by the riskiness of categories of assets, not by the riskiness of specific assets on the books," Mr. Sexton said.
So why are the nation's banks being subjected to an overlay of risk-based capital requirements?
Paul Horvitz, a University of Houston banking professor, cites two goals.
One, he says, was to force big banks into provisioning capital against off-balance-sheet activities such as interest rate swaps. The other was to encourage banks to denominate bigger portions of their balance sheets in marketable assets such as Treasury securities.
In short, U.S. regulators never intended that risk-based capital standards would supplant leverage minimums. Instead, they sought to supplement the leverage-ratio requirement by correcting its two biggest deficiencies: that it does not apply to off-balance-sheet risk and that it provides an incentive for high loan concentrations.
Cheering on Wall Street
Despite the capital-raising burdens, there is quite a bit of support for the leverage requirement on Wall Street. Analysts say equity concentrations play well to investors, quite apart from portfolio composition and macroeconomic considerations.
"Investors are worried more about the soundness of the bank than what an institution might be contributing to the economy in the way of loans," said Richard Stillinger, a bank analyst with Keefe, Bruyette & Woods Inc., New York.
The one factor that could help risk-based capital guidelines supplant the leverage ratio is the introduction of risk weightings for exposure to changes in interest rates, said Mr. Baer of the Chicago Fed.
Fed Chairman Alan Greenspan said that by early summer regulators would publish proposed capital guidelines for interest rate risk.
FDIC officials say the leverage component of their capital standards may be dropped if the expanded risk-based definitions work well.
But Mr. Greenbaum at Northwestern said both leverage and risk-based capital standards would probably be enforced strongly until the deposit insurance system is overhauled and lawmakers become convinced that tax dollars won't be needed to pay off depositors.
"Congress and the regulators are scared to death about the exposure of the bank deposit insurance fund," he said. "Insurance premiums can go only so high, so the alternative is to push on capital, and push very hard."