Global regulators have a peculiar way of assessing the soundness of big banks: Ask bankers how risky their investments are, then figure out if they have enough capital to absorb the potential losses.
This method, known as risk weighting, has failed repeatedly - most spectacularly during the 2008 financial crisis. The good news is that some smart regulators understand and are articulating the problem.
Like most firms, banks finance themselves with a combination of debt, which they get by taking deposits and issuing bonds, and equity, which they get from their shareholders. The latter, also known as capital, is crucial to the bank’s survival. If bad investments cause the value of a bank’s assets to fall, its equity decreases by an equivalent amount. If equity is depleted, the bank is insolvent. There will be either bankruptcy or some form of government bailout. Hence the need for capital requirements.
In thinking about whether a financial institution has enough equity, current practice - for example, as seen in the international banking regulations called Basel II and Basel III - is to compare it with a measure that places weights on the bank’s assets according to their riskiness. A bond with a rating of AAA and a face value of $1 million, for example, might not be counted at all, based on the (often erroneous) assumption that it would always pay out in full. So a bank with total assets of $2 trillion might have risk-weighted assets of only $1 trillion. With just $100 billion in equity, or 5 percent of assets, it could have a risk-weighted capital ratio of 10 percent.
In reality, the difference between simple equity ratios and risk-weighted capital ratios tends to be even larger. Consider Deutsche Bank, which reported a core Tier 1 capital ratio of 10.2 percent as of June 30. At the same time, its shareholder equity was slightly less than 2.5 percent of its total assets. The discrepancy was remarkably similar for the top 10 U.S. banks just before the financial crisis hit: The average headline capital ratio was about 11 percent, and the true ratio of equity to total assets was 2.8 percent.
So which measure is right? It’s not the risk-weighted one, as Andrew Haldane from the Bank of England and Tom Hoenig of the Federal Deposit Insurance Corp. (and formerly president of the Federal Reserve Bank of Kansas City) have pointed out in speeches.
One big problem is incentives. Bankers like to use as much borrowed money as possible, relative to their equity. This boosts the return to shareholders in good times, but also presents a threat to the financial system and the broader economy. If bankers are in charge of calculating their own risk weights, they will try to understate the risks. This happened with mortgage-backed securities and associated derivatives in the United States, with real-estate-related loans and assets in countries such as Ireland and Spain, and with sovereign debt in much of the euro area.
Second, regulators are no better than bankers at figuring out the right risk weights. For one, they are often heavily influenced by the bankers - a reality I have experienced personally in my conversations with central bankers and other officials, who meet with banking staff continually and even now are convinced that top executives really know how to measure and handle risk. Beyond that, they are out of their depth. The system of risk weights has become too complex, unwieldy and far too easy to game.
Actually, no one can calculate proper risk weights. They are unknowable. Analysts at credit-rating companies, even if one sets aside all the conflicts of interest they face, are just as prone to group think, fads and misconceptions as the rest of us. Academics would do no better. And the “wisdom of crowds” - as reflected in the market for credit-default swaps - suggested that Citigroup was a low-risk investment until 2007.
The right approach, as articulated by Hoenig, is to choose capital rules that are “simple, understandable, and enforceable.” The best available measure is the ratio of tangible equity to tangible assets. The term “tangible” excludes ephemera such as deferred tax assets, which banks can use to reduce their future tax bills only if they stay in business and generate profits.
The Basel III rules would nudge the required tangible equity ratio up to 3.25 percent, meaning that a 3.25 percent drop in the value of a bank’s assets could wipe out its capital. That is puny in a world that is becoming more risky. Look at the European debt crisis, think about China’s prospects, and reflect on what has happened to the U.S. economy in the past decade.
We should abandon the notion of risk weights and move the tangible-equity ratio back toward 20 percent. Investors in banks might not reap the same returns, but they would also be taking on less risk. As argued by Stanford University economist Anat Admati and her colleagues, the total funding cost of big banks probably wouldn’t increase. The reduced likelihood of severe financial crises would have a positive, not negative, impact on our medium-term growth.
The sooner risk weighting is dead and buried, the better off we will be.
Simon Johnson, a professor at the MIT Sloan School of Management as well as a senior fellow at the Peterson Institute for International Economics, is co-author of “White House Burning: The Founding Fathers, Our National Debt, and Why It Matters to You.”