FDIC Vice Chairman Calls Basel Risk Based Capital Standards "A Well Intended Illusion" That Creates Undercapitalized Banks: Prefers Simpler Equity To Assets Measure

Posted by Milton Recht:

From "Basel III Capital: A Well-Intended Illusion" by Thomas M. Hoenig, Vice Chairman, Federal Deposit Insurance Corporation, to the International Association of Deposit Insurers 2013 Research Conference, Basel, Switzerland, April 9, 2013:

Aristotle is credited with being the first philosopher to systematically study logical fallacies, which he defined as arguments that appear valid but, in fact, are not. I call them well-intended illusions.

One such illusion of precision is the Basel capital standards in which world supervisory authorities rely principally on a Tier 1 capital ratio to judge the adequacy of bank capital and balance sheet strength.***In contrast, supervisors and financial firms can choose to rely on the tangible leverage ratio to judge the overall adequacy of capital for the enterprise. This ratio compares equity capital to total assets, deducting goodwill, other intangibles, and deferred tax assets from both equity and total assets. In addition to including only loss-absorbing capital, it also makes no attempt to predict or assign relative risk weights among asset classes.***An inherent problem with a risk-weighted capital standard is that the weights reflect past events, are static, and mostly ignore the market's collective daily judgment about the relative risk of assets. It also introduces the element of political and special interests into the process, which affects the assignment of risk weights to the different asset classes. The result is often to artificially favor one group of assets over another, thereby redirecting investments and encouraging over-investment in the favored assets. The effect of this managed process is to increase leverage, raise the overall risk profile of these institutions, and increase the vulnerability of individual companies, the industry, and the economy.

It is no coincidence, for example, that after a Basel standard assigned only a 7 percent risk weight on triple A, collateralized debt obligations and similar low risk weights on assets within a firm's trading book, resources shifted to these activities. Over time, financial groups dramatically leveraged these assets onto their balance sheets even as the risks to that asset class increased exponentially. Similarly, assigning zero weights to sovereign debt encouraged banking firms to invest more heavily in these assets, simultaneously discounting the real risk they presented and playing an important role in increasing it. In placing a lower risk weight on select assets, less capital was allocated to fund them and to absorb unexpected loss for these banks, undermining their solvency.***Despite all of the advancements made over the years in risk measurement and modeling, it is impossible to predict the future or to reliably anticipate how and to what degree risks will change. Capital standards should serve to cushion against the unexpected, not to divine eventualities. All of the Basel capital accords, including the proposed Basel III, look backward and then attempt to assign risk weights into the future. It doesn't work.

In contrast, the tangible leverage ratio provides a simpler, more direct insight into the amount of loss-absorbing capital that is available to a firm. A leverage ratio as I’ve defined it explicitly excludes intangible items that cannot absorb losses in a crisis. Also, using IFRS [International Financial Reporting Standards] accounting rules, off-balance sheet derivatives are brought onto the balance sheet, providing further insight into a firm's leverage. Thus, the tangible leverage ratio is simpler to compute and more easily understood by bank managers, directors, and the public. Importantly also, it is more likely to be consistently enforced by bank supervisors.

The entire speech is available on the FDIC archive collection site.