In "Why 'Back to Basics' Is the Wrong Answer to Basel" (Sept. 19), Karen Shaw Petrou offers a critique of my comments on the Basel capital requirements presented at the American Banker Regulatory Symposium on Sept. 14. Those comments offered the view that abandoning the overly complex and ineffective Basel capital requirements for a straightforward and understandable tangible equity capital ratio would strengthen banks and the financial system.

Petrou argues that relying on this capital ratio is too simple and "akin to abandoning surgery with complex anesthesia for the bite-a-bullet option." Basel III is nearly incomprehensible to most readers, including bank directors, managers, and analysts. Of what use is a measure that no one can understand? Tangible equity capital is understood by all. Therefore, on its face, it is more useful. 

Petrou makes two primary criticisms. First, she claims that my "framework is premised on the belief that capital is the crux of bank regulation." Capital is essential to bank safety and soundness, but it is not sufficient for a sound financial system.  

Banks fail for lots of reasons, such as fraud and operational risks, which a reasonable minimum capital ratio cannot prevent. In fact, I argue that while capital is essential to a bank's health, it has its limits. I note that even high levels of capital cannot save a firm from bad management or save an industry from the cumulative effects of excessive risk taking. That is one reason why I emphasize that a strong supervisory examination process is equally as important as a strong minimum tangible equity ratio.

Second, Petrou argues that tangible assets – the denominator of my preferred minimum capital ratio – are inadequate because they do not account for off-balance sheet items such as derivatives and they encourage banks to invest in riskier assets. I agree that off-balance sheet items are important considerations, but my proposal would bring more capital to the balance sheet than the current Basel standards even as they attempt to account for off-balance sheet items. 

As for derivatives, I support moving to accounting standards, such as those used in Europe, that include gross measures of derivatives exposures on the balance sheet. Pretending that such risks don't exist or hiding them in the footnotes encourages excessive leverage and serves no useful purpose.

Yes, an unweighted capital ratio can lead to managers investing in riskier assets because it implicitly allocates the same percentage of capital to all assets regardless of risk. Again, a strong supervisory framework must accompany any capital standard that might be put in place. 

As Petrou notes, despite her support of Basel over a tangible equity ratio, the Basel requirements have repeatedly failed to provide adequate capital relative to the risks. In my remarks I pointed out that this was explained by the fact that Basel relies on central planners' determination of risks to set risk weights or on banks' internal models. The Basel risk weights are also backward-looking and do not adjust to the changing conditions and risks of the financial system. 

To address this problem, I've proposed a much higher minimum tangible equity capital ratio than what is used today. My minimum requirement would be higher than the minimum total risk‑-based ratio for a bank to be considered well capitalized under Basel III. The supervisory examination process would then be used to assess a bank's risk and judge whether this minimum required capital is adequate.  

This is not a foolproof method, but no such method exists for guaranteeing that there will be no future financial crises. However, I know from experience that well-trained, well-supported professional examiners can usefully assess a financial firm's fundamental operations, liquidity, asset quality and risk controls.

Some would argue that supervision was not effective during the boom years leading up to the crisis and therefore we should not expect supervision to be effective in preventing future build-ups of excessive risk exposures. I argue that if the financial supervisors' record needs improvement, the solution is to hold accountable the leadership of the regulatory agencies. The examination process, effectively conducted, holds the best potential to identify firm-specific risks and adjust capital levels as needed. 

Finally, as I noted in my Sept. 14 speech, strong capital ratios and supervision will not be enough to protect our financial system if we don't address the fundamental incentives to take excessive risk and increase leverage created by the explosive expansion of the safety net of deposit insurance, the discount window, and other forms of governmental support. 

As a result, we also need a fundamental restructuring that separates banking from market making and trading activities, a view which I have been espousing very publicly for some time. This would greatly enhance the supervision and market discipline pillars of the regulatory framework.

I am not so much in favor of a "bite the bullet" approach as I am concerned we are sewing together our own Frankenstein.

Thomas Hoenig is a director of the FDIC.