Bill Black: Higher Bank Capital Requirements are Necessary but not Sufficient to Prevent the Next Crisis

Yves here. Apparently out of reluctance to overburden readers with detail, Black skips over the big reason that Basel II was problematic. It relied on risk weighting of assets. For example, sovereign debt had a risk weight of zero, meaning banks weren’t required to hold equity against it. So guess what Eurobanks, who were subject to Basel II rules shortly before the crisis, loaded up on?

As former central banker London Banker put it:

I was looking at the preferred asset classes under the Basel Accords…and realised that every single asset class that is given less than a 100 percent credit risk weighting is now tainted by widespread default, scandals or bailouts.

The credit risk weightings mean that instead of reserving the standard 8 percent of capital in respect of a debt, the bank can cut that by the weighting applied to the asset class. Effectively, the reduction in credit risk weighting operates as a powerful subsidy to the borrowers and equally powerful incentive to over-leveraging the lenders.

Steve Waldman wrote a classic post on why bank equity isn’t the end all and be all of bank safety that Summers and Geithner would have you believe. From Capital can’t be measured:

The bottom line is simple. The capital positions reported by “large complex financial institutions” are so difficult to compute that the confidence interval surrounding those estimates is greater than 100% even for a bank “conservatively” levered at 11× tier one capital.

Errors in reported capital are almost guaranteed to be overstatements. Complex, highly leveraged financial firms are different from other kinds of firm in that optimistically shading asset values enhances long-term firm value…

Financial firms raise and generate liquidity routinely. Many of their assets are suitable as collateral in repo markets. Large commercial banks borrow freely in the Federal Funds market and satisfy liquidity demands in part simply by issuing deposits that are not immediately withdrawn. For large financial firms, access to liquidity is rarely contingent upon a detailed audit by a potential liquidity provider. Instead, access to liquidity, and the ability to continue as an operating firm, is contingent upon the “confidence” of peer firms and of regulators. Further, the earnings of a financial firm derive from the spread between its funding cost and asset yields. Funding costs are a function of market confidence, so the value of a financial firm’s real future earnings increases with optimistic valuation. For a long-term shareholder of a large financial, optimistically shading the firm’s position increases both the earnings of the firm and the “option value” of the firm in difficult times. It would be a massive failure of corporate governance if Jamie Dimon or Lloyd Blankfein did not fib a little to make their firms’ books seem a bit better than perhaps they are, within legal and regulatory tolerances.

So, for large complex financials, capital cannot be measured precisely enough to distinguish conservatively solvent from insolvent banks, and capital positions are always optimistically padded. Given these facts, and I think they are facts, even “hard” capital and leverage restraints are unlikely to prevent misbehavior. Can anything be done about this? Are we doomed to some post-modern quantum mechanical nightmare wherein “Schrödinger’s Banks” are simultaneously alive and dead until some politically-shaped measurement by a regulator forces a collapse of the superposition of states into hunky-doriness?

Yes, we are doomed, unless and until we simplify the structure of the banks. When I say stuff like “confidence intervals surrounding measures of bank capital are greater than 100%”, what does that even mean? Capital does not exist in the world. It is not accessible to the senses. When we claim a bank or any other firm has so much “capital” we are modeling its assets and liabilities and contingent positions and coming up with a number. Unfortunately, there is not one uniquely “true” model of bank capital. Even hewing to GAAP and all regulatory requirements, thousands of estimates and arbitrary choices must be made to compute the capital position of a modern bank. There is a broad, multidimensional “space” of defensible models by which capital might be computed. When we “measure” capital, we select a model and then compute. If we were to randomly select among potential models (even weighted by regulatory acceptability, so that a compliant model is much more likely than an iffy one), we would generate a probability distribution of capital values. That distribution would be very broad, so that for large, complex banks negative values would be moderately probable, as would the highly positive values that actually get reported….Given the heterogeneity of real-world arrangements, no “one-size-fits-all” model can be legislated or regulated to ensure a consistent capital measure. We cannot have both free-form, “innovative” banks and meaningful measures of regulatory capital. If we want to base a regulatory scheme on formal capital measures, we’ll need to circumscribe the structure and composition of banks so that they can only carry positions and relationships for which we have standard regulatory models. “Banks’ internal risk models” or “internal valuations of Level 3 assets” don’t cut it. They are gateways to regulatory postmodernism.

By Bill Black, the author of The Best Way to Rob a Bank is to Own One and an associate professor of economics and law at the University of Missouri-Kansas City. Cross posed from Benzinga

The last ditch efforts to save Larry Summers’ prospective nomination to run the Fed and the comments about his withdrawing from consideration have prompted further discussions of financial regulation. The thrust of the comments is that Summers’ big regulatory idea was that capital requirements are the key and other forms of rules are worthless because they are easy to evade.

Commercial bank capital requirements during the heights of the bubbles were absurdly low and the capital requirements for investment banks, Fannie and Freddie, sellers of CDS protection, monoline insurers, and mortgage banks were farcical. The capital requirements for U.S. primary dealers and the largest commercial banks were reduced sharply during the expansion phase of the bubble. The reduction in the capital requirements for Europe’s largest commercial banks was far more severe than in the United States, so there is a “natural experiment” that can be used to research the effect of reducing capital requirements.

The Basel process was originally designed to prevent a regulatory race to the bottom by the “developed” economies through debasing bank capital requirements. The Basel process was supposed to create a more uniform minimum bank capital requirement. Basel II, however, embraced reducing capital requirements and ended up producing a much lower bank capital requirement in Europe than the U.S.

Basel II’s evisceration of capital requirements proved disastrous. One of the less understood aspects of the mortgage fraud crisis is how the FDIC’s successful rearguard action saved us from the Fed’s economists’ efforts to push the full reduction in capital requirements of Basel II and delayed U.S. implementation of Basel II by two years. Europe had no equivalent to the FDIC fighting the madness of Basel II’s sharp reductions in bank capital requirements so it adopted the full reduction and it adopted that reduction two years before the U.S. implemented its considerably less radical reduction in capital requirements.

The perversion of the Basel process in Basel II into a device for leading, rather than preventing, a regulatory race to the bottom began in 1998 under the Clinton administration. The perversion was led by the lobbying of the largest banks and the Fed. Basel II was drafted in a manner that was a radical departure from Basel I. The difference was that the industry was invited “inside the tent” by the regulators to participate actively in the rule making process. This invitation went well beyond the input U.S. firms have in “notice and comment” rulemaking. The largest banks were constantly involved – for the better part of a decade – making numerous ex parte presentations to individual government employees and committees. The biggest bank strategy had several components that all favoring reduced capital requirements for the largest banks.

The U.S. government’s embrace of the regulatory race to the bottom and of a process dominated by the largest banks was consistent with the Clinton administration’s embrace of both of those concepts. President Clinton and Vice President Gore’s “Reinventing Government” crusade had seven key precepts for financial regulation that I have explained in detail in prior articles.

1. “Don’t waste one second worrying about fraud….” (Bob Stone’s explanation of the advice he gave Gore that led Gore to put him in charge of the “Reinvention” crusade)

2. The industry members are the regulators’ “customer” – the public and Nation are not

3. The U.S. must “win” the international competition in regulatory laxity (Summers’ rationale for favoring the repeal of Glass-Steagall and the creation of the regulatory black hole for financial derivatives via the Commodities Futures Modernization Act of 2000)

4. Financial regulators were direct to “partner” with the banks

5. Financial regulators were directed to cease “imposing” rules and instead to “negotiate” them with their industry “partners”

6. Clinton told the financial regulators at his first major meeting with them that he had received more criticism of their actions while he was campaigning than any other branch of government

7. The Reinventers were particularly disdainful of enforcement actions and prosecutions against fraudulent firms and firms that polluted or otherwise endangered worker or public safety for this violated the central mission of treating the firms as customers and partners

Bob Rubin and Larry Summers were enthusiastic supporters of the Reinventing Government crusade. I have not been able to find any record of them opposing the effort under the Clinton administration to use Basel II as a means to cause a dramatic reduction in capital requirements for the largest banks.

After the Bush administration began, another Rubinite, Timothy Geithner, was made head of the NY Fed on October 15, 2003. The NY Fed’s economists played a key role in the Fed’s support for the weakest possible Basel II capital requirements under Geithner and his predecessor. The Fed’s economists ignored and denigrated their supervisors’ objections to the severe reduction in capital requirements. Report of the Financial Crisis Inquiry Commission (FCIC) 2011: 171 (see also the Spillenkothen memorandum to FCIC).

The proposed Basel II reduction in capital made a mockery of U.S. law requiring the regulators to take “prompt corrective action” against banks with inadequate capital.

[T]he results of the Fourth Quantitative Impact Survey (QIS4), conducted during the fall and winter of 2004-2005, exacerbated these concerns. This survey of 26 of the largest banks in the U.S. (including the banks that would be required to adopt the AIRB) showed substantial reductions in required capital on average. Indeed, if these banks had chosen to reduce their capital to these AIRB minimums, almost all of them would have had leverage ratios that would be categorized as undercapitalized and triggering prompt corrective action sanctions.

To put this all together, we have a real world test of administration economists’ views and integrity. The Basel II rule adopted by the U.S. was very poor, but because of the FDIC’s courage and skill it was far less destructive than the version of Basel II that the Fed’s economists championed and that Europe adopted. The Fed/European version was indefensible. It was contrary to the express will of Congress, all financial regulatory experience, and sound economic theory. By looking at their contemporaneous positions on Basel II we can judge officials’ actual views on capital requirements. For example, Geithner is famous for claiming (now) that the key to regulation is “capital, capital, capital” – by which he means higher capital requirements.

Geithner, however, was one of those who led the crusade to lower capital requirements for the largest banks.

Summers’ supporters claim that he was “long” a supporter of higher capital requirements for banks. Jeremy Bulow wrote that Summers was the best person in the world to replace Ben Bernanke as head of the Fed. Bulow claimed that Summers was a great regulator.

Because Summers has opposed some poorly designed rules, he is criticized as being against regulation. Actually, he’s been in favor of regulating wisely. For example, he … has long supported requirements to boost bank capital.

“[H]e’s in favor of regulating wisely” and he opposes bad rules – how unique. There’s no content to this syrup. The last sentence can be tested. The Clinton Treasury could have killed Basel II’s radical reduction in capital requirements for the largest banks. Rubin and Summers (and Clinton and Gore) also could have stopped the biggest banks’ constant ex parte ability to structure the rule to radically reduce their capital requirements. We know that Treasury did not kill either the rule or the disgraceful manner in which the largest banks dominated the rule changes. But perhaps Summers did actually write to oppose the rule and the ex parte procedural abuses and was overruled by Rubin or Clinton. If he did, then he deserves considerable praise. The question for Bulow is how long does “long” mean in his second sentence quoted above. Does Bulow know that Summers believed in 1998 that the largest banks needed higher capital requirements? If Summers did believe that in 1998 what did he do to try to stop the disaster that bore bitter fruit as Basel II. Did Rubin and Summers implore Geithner to stop pushing to weaken bank capital requirements in the early-to-mid 2000s?

Similarly, after Summers withdrew his name from consideration, Edward Luce wrote to defend Summers’ regulatory vigor, arguing that Summers, by 2009, supported “much stricter” bank capital requirements.

Luce explains Summers’ theory of regulation.

Mr Summers’ real bias is his tendency to dismiss smaller regulations as self-defeating. He prefers big and simple to complex and gameable.

The problem I have is with Summers’ assumption that “capital” is not “gameable.” Capital is simply an accounting residual: Assets – Liabilities = Capital. If a CEO leading an accounting control fraud can “game” assets (by overstating them) and/or understate liabilities, then the CEO will “game” (overstate) capital (and income) – massively. Banks, and corporations like Enron, that are massively insolvent and unprofitable can through accounting fraud report for many years that they have record profits and “excess” capital. The famous 1993 article by George Akerlof and Paul Romer – “Looting: The Economic Underworld of Bankruptcy for Profit” confirmed the accuracy of what competent regulators and white-collar criminologists had been saying for years. Accounting fraud was a “sure thing” that mathematically guaranteed the ability to report record (albeit fictional) profits for years, which made the controlling officers immediately wealthy through modern executive compensation. The firm might fail, but the controlling officers could walk away wealthy.

Summers and many of his supporters still don’t understand the most basic aspects of accounting control fraud. Accounting control fraud epidemics have driven our three modern financial crises (the S&L debacle, the Enron-era frauds, and the ongoing mortgage fraud crisis). We cannot afford the continuing unwillingness of neoclassical economists to read the work of a Nobel laureate in economics (Akerlof 2001) because of their primitive tribal taboo and ideological dogmas against taking elite fraud seriously. There would have been a fourth modern crisis had not the S&L regulators driven liar’s loans out of the housing industry (on the grounds that they were inherently fraudulent) in 1990-1991 and the S&L debacle would have been massively more expensive had the S&L regulators listened to the economists’ claim that fraud by the officers controlling banks was a “distraction.” Note that we did increase S&L capital requirements, but we never made what would have been the catastrophic mistake of believing that accounting fraud could not be used to “game” the higher capital requirements that we imposed. Our most effective rule restricted growth – it killed the remaining accounting control frauds even when Congress prevented us from gaining additional funds to close the remaining frauds.

Now that we can at least hope that the administration will cease attacking one of its most successful appointees, Janet Yellen, it is my hope that we can have a serious discussion about what it takes to be an effective financial regulator. We know how to do it. We showed how to do it in even more hostile circumstances in which the Reagan administration was virulently opposed to our actions “reregulating” the S&L industry. Indeed, they called us “reregulators” because they considered that term to be the most repugnant, the most redolent of incomprehension, term in their lexicon with which they could insult us.

Summers and his supporters and Yellen and her supporters should talk with us at length and take advantage of what we learned, including the mistakes we made. Restoring effective regulation, supervision, and prosecutions of elite bankers is one of the most important tasks our Nation faces. The arrogance of the last three administrations in the regulatory context is staggering. Never have officials boasted so much about their purported “genius” while promoting policies that proved so destructive – and then cashed in and gotten rich through ties with the CEOs that grew wealthy by directing the control frauds that caused the mortgage fraud crisis.

My view is that if a “genius” economist cannot maintain the batting average of a journeyman batter (.250) they not only are not a genius, they are the guy that gets cut from the minor league team because they cannot hit a curve. The last three administrations and the Washington, D.C. (non) “think tanks” have been filled with economists with (predictive) batting averages of around .125 and weak gloves and errant arms – all of them supposedly brilliant. There were hundreds of Office of Thrift Supervision examiners whose opinions repeatedly proved vastly superior to the economists’ predictions during the S&L debacle. Akerlof and Romer concluded their 1993 article with these sentences in order to emphasize this message to their peers.

The S&L crisis, however, was also caused by misunderstanding. Neither the public nor economists foresaw that the [deregulation] of the 1980s were bound to produce looting. Nor, unaware of the concept, could they have known how serious it would be. Thus the regulators in the field who understood what was happening from the beginning found lukewarm support, at best, for their cause. Now we know better. If we learn from experience, history need not repeat itself. (Akerlof and Romer 1993: 60)

Larry and Janet: please listen to the regulators in the field. Please end Ben Bernanke’s practice of placing economists in charge of Fed supervision. The Fed’s economists are a major source of the Fed’s problems. They are not the solution. If they are transformed they can be part of the solution, but the solution needs to come from the people in the field. That is particularly true with regard to detecting systemic risks. End of the glaring conflict of interest in having your examiners and supervisors be employees of the regional Fed banks which are owned by the banks they are supposed to examine and supervise.