Time for bankers to have a capital rethink

US bankers like JPMorgan’s Jamie Dimon fear increased bank regulation. Chuck Hagel/Flickr, CC BY

A plan by US regulators to impose greater capital requirements on the nation’s eight biggest banks has prompted complaints it will put the banks at a global disadvantage.

The proposal is that the banks - Bank of America, Bank of New York Mellon, Citigroup, Goldman Sachs, JPMorgan Chase, Morgan Stanley, State Street and Wells Fargo – would have to meet a leverage ratio (the rate of lending to equity) of 5%, rather than the 3% to be required of their smaller local and international peers. A 5% ratio implies in essence that at least 5% of bank assets have to be funded by equity, that is bank capital.

The ratio is proposed by the Basel Committee on Banking Supervision for global implementation, and is likely to be closely watched by Australia’s bankers as they debate regulation levels as part of the current financial system inquiry being led by David Murray.

Will it really harm the banks?

Despite the US banking sector’s complaints, it’s not clear to what extent this change could challenge them. An alternative to raising additional capital would be to reduce their offerings of banking products such as loans, loan commitments, and letters of credit. That choice will particularly depend on the state of the economy during the four years of transition that would be involved. Banks might close the gap between the actual and the target leverage ratio by reducing their asset exposure in a recession, but seek additional capital during good times.

The leverage ratio is part of the Basel III banking regulations that are being implemented globally. For most institutions the leverage ratio requires a minimum of 3% capital relative to total assets (and asset equivalents for off-balance sheet exposures such as derivatives, loan commitments and financial guarantees).

Next to the leverage ratio, Basel III proposes an increase in the quantity and quality of risk-based bank capital. Banks will be required to hold more Tier 1 capital (such as paid-up capital and retained earnings) in absolute terms and relative to Tier 2 capital than they had to under Basel II. The risk-based Basel III capital increase might include a counter-cyclical capital buffer that banks would be required to build during economic booms. Basel III also proposes minimum ratios for short-term and long-term bank liquidity.

In a post-GFC world, isn’t more regulation a good thing?

The US proposal comes at an interesting time for Australia. The International Monetary Fund has recommended that Australia’s top four banks should be subject to heightened supervision, strong recovery and resolution planning, and higher potential to absorb and cover future losses.

In addition, the financial system inquiry will be looking at the trade-off between bank efficiency and resilience, given capital and liquidity regulation, as part of its considerations.

Recent research has suggested banks have nothing to be concerned about from capital regulation as it doesn’t affect the value of a firm.

They conclude that capital regulation in general, and the increase of regulatory capital in particular, has no impact on financial institutions’ performance or operations such as lending. Increases in capital requirements can increase financial system stability without creating additional costs, they say.

However, the banking sector has not supported this theory and the interaction between capital and bank efficiency remains unclear.

The risk-neutral leverage ratio complements risk-based capital ratios and liquidity ratios as a third key regulatory tool. The leverage ratio is very controversial in the industry for a variety of reasons.

For capital requirements, the leverage ratio introduces a relative floor and hence fixed costs for banking assets. Risk-reducing, risk-free and low risk activities may be charged with higher capital than indicated by the risk-based capital ratio, which may set counter-intuitive incentives for banks. In other words, because the leverage ratio doesn’t take into account risk profile, banks may have an incentive to hold riskier assets.

Also, the leverage ratio conflicts with liquidity ratios. This is because banks often hold assets for liquidity reasons and would face an extra charge, from the leverage ratio, for having these risk-reducing investments. The same would apply to other risk-offsetting but asset-positive - and hence capital increasing - strategies.

Banks argue that regulation, and in particular the leverage ratio, limits their efficiency with the result being a lower supply of credit and/or higher prices on consumer and corporate loans.

Trade letters of credit have been identified as an areas that may be most impacted by the increased leverage ratios. It comes to no surprise that Jamie Dimon, chief executive of JPMorgan Chase, estimates the cost of trade finance would increase by up to 75 basis points. This number is extremely large relative to current bank spreads and may be interpreted as a direct cost of regulation.

If other products incur similar costs of regulation, then the additional annual cost on the US financial industry may be in the area of US$100 billion (based on total banking assets of approximately $17 trillion). These costs would have to be balanced with the benefits of a more resilient financial system. The recent global financial crisis has led to major costs for financial institutions, their stakeholders and last but not least taxpayers.

With the trade-off between efficiency and the resilience of banks unclear, careful consideration will be needed.