May 21, 2013

Besides setting the target for bank capital, we need to think about how to get there.

Sir, Anat Admati and Martin Hellwig write that “capital ratios in Basel III rely on a complex, distortive and manipulable system of risk-weights”, “Banks are not a special case on debt-equity ratio” May 21.

They are absolutely correct, on all three counts, and that is applicable to Basel II too. But what I would like to mention is the curious fact that the “distortive” element, and which to me is the most serious flaw of Basel regulations, as it affects not only the banks but the whole market too, has received the least of attention.

There is no doubt that we need to go down the route of substantially increasing the capital requirements of banks, whether to the 8-12 percent level I favor, or the 25-30 percent level Admati and Hellwig favor. But, when considering the fact that bank capital is going to be extremely scarce while travelling on the route to the final bank capital that is needed, we should not forget that the distortive effects of the risk-weights will be more important than ever.

In this respect I opine that regulators, more than thinking about how to force bank capital increases, need to think in terms of how to help these increases to happen as fast and as smooth as possible. There might be many other ways, but personally I favor either large public sector capital injections in the banks accompanied by clear rules as to how current shareholders could repurchase that capital in order not to be diluted, or some strong tax incentives awarded to any bank that achieves a capital increase which in the short term meets the final long term target.