Introduction
The 2008 banking collapse, leading to the most severe recession since 1929, prompted a wide-ranging set of efforts to insure it did not happen again. These actions have included requiring banks to hold larger cash balances and more precise definitions of the risk levels of various bank assets. The result? A new industry of “risk” professionals working for banks and bank regulators has emerged. Here, I spell this out in more detail, explain why it will not work and what should be done.
The ABCs of Bank Regulation
Banks take in cash as deposits. They are required to keep less than 10% of these on hand to cover the normal fluctuations between new deposits and withdrawals. The rest of their deposits (90%+) remain for bank investments. In the past, banks were supposed to cover most of their costs via the “spread” – the difference between what they could earn on their investments and what they had to pay to attract deposits. Banks knew their very survival depended on the safety of their investments (mostly loans to businesses and mortgages). As a consequence, they took great care to make sure they made safe investments. Any old time banker will tell you the bank staff spent a good deal of time making sure their borrowers were OK and helping them in any way they could.
In 1999, provisions of the Glass-Steagall Act that prohibit a bank holding company from owning other financial companies were repealed. As a result, banks have increasingly “bundled” their investments and sold them off for commissions. Note what this does to the internal incentive structures of banks: instead of having their very existence depending on the safety of their investments, generating commissions gets top priority. So how can banks maximize commission income? By making as many loans as they can and selling them off. So what then happens to banks’ concern over the safety of their loans? It disappears: just make as many loans as possible and sell them off for commissions.
Enter the Basel Accords
The Basel Accords are an attempt to regulate bank safety by providing different “safety weights” to bank assets. Countries do not need to apply them but most European Union countries do and the US regulations approximate whet the Accords require. Even though there are now three Accords with a fourth on the way, their essence is encapsulated in the 1988 Basel I Accord. Basel I created a bank asset classification system. This classification system grouped a bank’s assets into five risk categories:
• 0% (no risk) – cash, central bank and government debt and any OECD government debt;
• 0%, 10%, 20% or 50% – public sector debt;
• 20% – development bank debt, OECD bank debt, OECD securities firm debt, non-OECD bank debt (under one year maturity) and non- OECD public sector debt, cash in collection;
• 50% – residential mortgage packages/derivatives;
• 100% – private sector debt, non-OECD bank debt (maturity over a year), real estate, plant and equipment, capital instruments issued at other banks.
These weights were applied to a bank’s assets. Their total is called a bank’s risk-weighted assets (RWA). Banks were required to maintain capital (cash or near-cash) on hand equal to at least 8% of its risk-weighted assets. For example, if a bank has risk-weighted assets of $100 million, it is required to maintain capital of at least $8 million. Since 1988, the regulations have grown and become increasingly complex.
Today’s Regulations
The banking collapse of 2008 led to a ratcheting up of bank regulations. The clearest manifestation of this was passage of the Dodd-Frank Act (2010) that applies numerous new restrictions and reporting requirements on banks. One indication of just how complex things have gotten is seen in the growing length of the annual reports of major banks. In 2007, the JPMorgan Chase annual report was 192 pages. In 2016, it was 328 pages, with most of the additional pages explaining how they complied with regulations.
A taste of what this entails can be gained via excerpts from the 2016 report:
As of December 31, 2016 and 2015, the lower of the Standardized or Advanced capital ratios under each of the Transitional and Fully Phased-In approaches represents the Firm’s Collins Floor, as discussed in Monitoring and management of Capital section:
• The Tier 1 leverage ratio is calculated by dividing Tier 1 capital by adjusted average assets.
• The SLR leverage ratio is calculated by dividing Tier 1 capital by SLR leverage exposure.
• Represents the Transitional minimum capital ratios applicable to the Firm under Basel III as of December 31, 2016 and 2015. At December 31, 2016, the CET1 minimum capital ratio includes 0.625% resulting from the phase-in of the Firm’s 2.5% capital conservation buffer and 1.125%, resulting from the phase-in of the Firm’s 4.5% global systemically important banks (“GSIB”) surcharge.
• Represents the minimum capital ratios applicable to the Firm on a Fully Phased-In Basel III basis. At December 31, 2016, the ratios include the Firm’s estimate of its Fully Phased-In U.S. GSIB surcharge of 3.5%. The minimum capital ratios will be fully phased-in effective January 1, 2019. For additional information on the GSIB surcharge, see page 79. (e) In the case of the SLR, the Fully Phased-In minimum ratio is effective beginning January 1, 2018.
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