The Sept. 12 announcement by the Basel Committee on Banking Supervision for higher minimum capital standards tackles just one facet of effective risk management.
The other facet is the institution's risk level, which should be informed by its risk appetite. Bank soundness flows from a combination of capital levels and risk levels.
Financial reform is necessary, and we endorse efforts to manage risk throughout the enterprise. It's important for policymakers and the public to understand that capital levels alone will not protect us from another crisis. Proper supervision of underwriting standards and proper specification of risk-based capital requirements are keys to bank soundness.
As the industry recovers from the economic crisis, senior management and board members must focus on their risk tolerances, then define them so that they become part of the bank's culture. A study the Risk Management Association conducted last year with Oliver Wyman clearly indicates that CEOs and CROs who effectively communicated their bank's risk appetite to those taking and managing risks outperformed the competition.
A well-functioning financial system needs banks to invest in prudent risk positions that generate an appropriate level of earnings. To encourage that investment, capital required for risk positions has to be proportionate with an institution's risk appetite.
Unlike the Basel II capital requirements, the 7% capital ratio to be phased in by 2019 is not risk sensitive.
In fact, it's only one percentage point lower than the 1988 Basel I requirement of 8% that global regulators abandoned because it led to capital arbitrage.
The committee has recognized the shortcomings of the previous Basel II generation of minimum capital requirements and has taken significant steps to improve the risk-based nature of the capital requirements going forward (the reforms pertaining both to credit risk and market risk).
Further, new supervisory emphasis on origination procedures and other Pillar 2 initiatives, including new supervisory emphasis on Pillar 2 stress testing and new Pillar 2 requirements for understanding the loan portfolios underlying securitizations, will bear the burden of protecting against future credit excesses.
But the increased capital ratio has not reduced banks' risk. In fact, the higher ratio may elevate it because the ratio is less risk related than the capital requirements it replaced.
Under the new rule, truly low-risk credit positions have the same multiple capital add-ons applied to them as do truly high-risk positions.
The unintended consequence of the new ratio is that the bank with the safe portfolio is now being held to a higher measurable level of soundness than the bank with the portfolio containing high asset value correlations.
Truly low-risk assets will generally have low yields.
Banks forced to hold high capital for these low-risk assets cannot afford to invest in them because of the low return on equity. As a result, banks lose a steady stream of net interest margin that, if regulatory capital standards had been set appropriately, would allow banks to boost retained earnings (i.e., add to capital) at low risk.
This hurts, rather than helps, bank soundness because it will cause some banks to seek higher-risk assets in order to earn an adequate return on the higher capital ratio requirements, leading to one or both of these outcomes:
The booking of higher-risk activities at banks, especially in countries with inadequate bank-by-bank supervision, or in countries with adequate supervision, the shrinkage of the regulated banking sector and a reduction in its ability to finance an economic recovery.
(For banks in these well-supervised countries, this regulatory decision is akin to raising taxes in a bad recession and could contribute to another banking crisis in a few years.)
The older Basel II standards were based on over a decade of good work by regulatory agencies. The elements of the old Basel II system that failed — such as securitization capital requirements based on external credit ratings, or trading desk capital requirements based on inappropriate VaR models — have been fixed by recent Basel advancements in risk-based capital requirements.
My organization has been providing independent analysis on matters pertaining to risk and capital regulation since 1999. The RMA has stressed that capital requirements should always, as accurately as possible, reflect the risk associated with bank exposures.
Capital requirements that are not accurately risk based, whether too low or too high, can harm bank soundness.
