Saturday, February 5, 2011

Why Optimal FinReg Isn't Even on the Table

. Saturday, February 5, 2011

Here's a nice little illustration of the difference between technological desires and political realities in financial regulation:

What is the optimal level of capital that a bank should hold? The new Basel III agreement sets a minimum level of 7% core Tier 1 capital, whose definition has been sufficiently tightened to consist almost largely of common equity. Under the Basel II rules, a bank could get away with just 2% common equity. But if Bank of England Monetary Policy Committee member David Miles is to be believed, regulators should really be forcing banks to hold as much as 20% core Tier 1 capital.

Miles, in other words, wants a 500% increase from Basel I and II in the amount of Tier 1 capital banks would have to hold. And maybe he's right: maybe that is the right amount. But that's basically irrelevant:

The Basel Committee calculated that just raising core Tier 1 capital ratios to 7% would require the world's 94 biggest banks to raise €600 billion ($821 billion) of equity, based on December 2009 balance sheets. If U.K. banks had to raise capital ratios to 17%, they would need an extra £757 billion ($1.2 trillion), more than twice their current market capitalization, according to UBS.

That is probably impossible in the current environment. As the article notes, Modigliani-Miller posits equivalence between debt and equity in the long run, but we're very much in the short run.

There's also a nice bit about the relationship between government policy and market expectations, and the political controversies over a supposedly technocratic policy.

As regulators have learned with Basel III, it doesn't matter how long banks are given to transition to higher capital requirements, the market will hold them to the higher standard straight away, a process known as superequivalence.

Still, Mr. Miles's analysis is useful in one respect; it shows the clear direction of thinking in U.K. official circles. British policy makers pushed hard in Basel for a minimum core Tier 1 ratio of 10%, supported by the U.S. and Switzerland. They are now winning support on the Financial Stability Board, which is overseeing the global overhaul effort, that the proposed additional capital buffer for too-big-to-fail banks should take the form of common equity. The U.K.'s Independent Commission on Banking also is considering further capital requirements for British banks over and above anything Basel demands.


Why Optimal FinReg Isn't Even on the Table
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