The latest news out of Basel is that the Basel Committee on Banking Supervision is considering the adoption of the leverage ratio — a simple ratio of capital to assets — as a "supplement" to the incredibly complex regime of risk-based capital requirements that emerged not long ago from many years of deliberations.
This would mark a significant change of position for the committee, and one apparently prompted by recent developments in the financial markets.
I take particular satisfaction in this development. As a member of the committee for six years, I argued on a number of occasions for the adoption of the leverage ratio as a capital standard, only to be rebuffed (quite politely) by the non-U.S. members, who did not use the ratio in their home countries.
In the United States, of course, the leverage ratio has been part of the capital rules for banks since the enactment of the Federal Deposit Insurance Corporation Improvement Act of 1991. As a result, our whole regulatory system of prompt corrective action is grounded in the leverage ratio.
Banks must have a leverage ratio of 5% to be considered well capitalized, and 4% to be adequately capitalized. If the ratio falls below 4%, the bank is considered undercapitalized; if it falls below 3%, the bank is considered significantly undercapitalized. Congress expressly provided that if the ratio were to fall to 2%, the bank would be considered critically undercapitalized.
The bank regulators must take increasingly stringent corrective actions to restore capital as the ratio falls into lower ranges, and they must take the most stringent actions when the 2% threshold is reached. Congress presumably believed that this 2% "cushion" would give the regulators time to act before an insolvency occurred that forced the bank to close.
As the new Basel rules came to be debated in the United States, there were a number of issues raised about our use of the leverage ratio. Those domestic banks that expected Basel II to lower their regulatory capital feared that the ratio would create a floor under capital that would prevent full realization of the benefits of the lower capital and would thus put them at a disadvantage compared to foreign competitors.
Former Federal Reserve Board Chairman Alan Greenspan argued that the new risk-based system represented an "evolution" from a leverage-based system. He opined that "at the end of the day, they are mutually exclusive," and that it would not be possible to have "some merger of a leverage ratio and risk-based capital systems."
His views were echoed by former Fed Gov. Susan Bies, who said the leverage ratio "has got to disappear."
The concept of "risk-based" capital has some obvious intellectual appeal. Why should a bank be required to hold the same capital against a Treasury security as against a loan to a marginal borrower? But the current crisis in our financial markets illustrates just how dicey the process of "risk weighting" assets can be.
For example, Basel II gave quite favorable treatment to assets bearing the highest ratings from recognized agencies. But our recent experience with triple-A obligations casts serious doubt on the reliability of such ratings, particularly as a guide for corrective action by bank regulators. Complicated, model-driven calculations of the probability of default over a one-year period, the loss given default, and exposure at default — the building blocks of Basel II's internal ratings-based approach to capital requirements — are not of much use to the supervisor facing an imminent need for triage.
What examiners need to assess in a deteriorating situation is whether the bank can avoid insolvency during the time it will take to recapitalize, merge, or effect a solvent liquidation. And what the FDIC needs to gauge is the prospective loss to the Deposit Insurance Fund if the primary supervisor acts too late. This means knowing what a bank's assets are currently worth — or, perhaps more to the point, what they can be sold for.
The Basel formulas for risk-weighting assets may give some sense of the longer-term value of a bank's assets, but they are not intended to be and cannot serve as determinants of current market values, let alone liquidation values.
The simple fact is that Basel II — with its mind-numbing complexity and the enormous costs required for its implementation — is not a useful tool for averting the kind of disasters we have seen recently. That the Basel Committee itself is now turning to the leverage ratio seems to reflect its own awareness of this fact. While adoption of a leverage ratio requirement would have significant benefits, it will not realize its promise unless regulators adhere to two important preconditions.
First, capital must be measured accurately; regulators must know what the real value of capital is. It makes no sense to put great weight on regulatory capital as a protection for shareholders, for the public, and for the financial system if supervisory decisions are based on historical book values and the real value of capital is ignored.
This means that some form of fair-value accounting is essential if regulators are to know what the value of capital really is. The Basel Committee, at least during my membership, viewed fair-value accounting as an anathema — a curious position, I always thought, for a group that put such cosmic importance on capital. But unless regulators focus on the real value of capital, they will operate in a fool's paradise, in which massive shortfalls in capital can develop virtually overnight.
Second, regulators must honor the 1991 law's mandate, and the compelling logic of prompt corrective action, by moving with speed and decisiveness to cure capital shortfalls when they occur. There is no better protection for all of the interests that regulators must protect than swift action to force recapitalization before real capital is exhausted.
A natural inclination for many bankers is to resist raising capital, because of the painful dilution it can cause for existing shareholders. But for supervisors to forbear from action while focusing on the nominal value of capital is a recipe for disaster, as we are learning to our dismay every day.