August 20, 2013

FDIC, please go the full way, and rid the banking system of all distorting capital requirements based on risk-weights

Sir, Thomas Hoenig of FDIC should be commended for putting forward such level headed arguments for a higher cap on a bank’s leverage ratio, which would significantly increase the capital requirements for banks, “Safe banks do not mean slow economic growth”, August 20.

And I absolutely agree with the title, that is, if the increases to where the final capital should be, happens fast and is not the result of a long and protracted process. I would, if I was the state and had some bad conscience about having permitted banks have so ridicule little capital before, help them along in the capital increases with some tax benefit packages for their shareholders. This, especially if banks agree to take that cap even higher, say 10 percent. 

Where I disagree though with Hoenig is when he writes “we would also be using Basel risk-weighted capital requirements to complement the leverage ratio and thus mitigate the potential for arbitrage”. And that because some argue that, as a result of the cap, banks could load up on riskier assets.

First, Basel’s risk-weighing does not reduce the risk of the system. On the contrary, it helps to push banks excessively into the arms of what is ex ante perceived as “absolutely safe” assets, which are precisely those assets that have caused the greatest bank disasters.

And second, worse, neither does it reduce the potential for arbitrage. With the risk weighting, the only thing the regulator achieves is to influence the arbitrage process. And in doing so, by favoring the access to bank credit of the AAAristocracy over that of the “risky” medium and small businesses, entrepreneurs and start ups, the regulator dangerously distorts the allocation of bank credit in the real economy.

Hoenig ends writing “The US is a market economy, and we know that bank capital is a source of strength, not a burden”. Absolutely! But, if one has a market economy, he should also know that nothing is gained, and perhaps much lost, by decreasing the possibilities of banks to exercise the reasoned audacity we expect from them, and increasing their risk-aversion. This, most especially, in the land of the brave.