Simon Johnson: Capital Failure

The Group of 20 summit for heads of government this weekend will apparently hail bank reform, particularly as manifest in the Basel III process that has resulted in higher capital requirements for banks. According to leading authorities on the issue, however, the Basel process is closer to a disaster than a success. 

Bank capital can be best thought of as the amount of financing of a banks operations (lending and investment) covered by equity and not by debt obligations. In other words, it describes the share of a banks assets subject not to the hard claim of debt but rather to a residual or equity claim, which would not lead to distress or insolvency when the value of the asset declines. For global megabanks, equity capital is thus a key element in preventing the failure of an individual institution (or a couple of banks) from bringing down the financial system. 

The framing of the Basel success, according to officials, is that the big banks wanted to keep capital standards down and this is definitely true but that governments pushed for requirements that are as high as makes sense. The officials implicitly conceded the banks main intellectual point, that higher capital requirements would be contractionary for the economy. 

But according to top academic experts on this issue people who know more about banks and bank capital than anyone else on the planet the banks have misrepresented and the officials have misunderstood reality. 

In a letter published in The Financial Times this week, Professor Anat Admati of Stanford University and her colleagues a Whos Who of finance (see for yourself) make three main points. 

First, the basic economics behind official thinking is wrong. 

Some claim that requiring more equity lowers the banks return on equity and increases their overall funding costs, thus lowering economic growth, the professors write. This claim reflects a basic fallacy. Using more equity changes how risk and reward are divided between equity holders and debt holders, but does not by itself affect funding costs. 

They go on to say: High leverage encourages risk taking and any guarantees exacerbate this problem. If banks use significantly more equity funding, there will be less risk-taking at the expense of creditors or governments. 

Second, the Basel process uses dysfunctional methods to adjust capital requirements to reflect the risk of various kinds of assets. 

The Basel accords determine required equity levels through a system of risk weights, they write. This system encourages innovations to economize on equity, which undermine capital regulation and often add to systemic risk. The proliferation of synthetic AAA securities [around U.S. housing loans] before the crisis is an example. 

Third, capital requirements should be simplified and greatly increased relative to what the Group of 20 leaders will congratulate themselves on. 

Lending decisions would be improved by higher and more appropriate equity requirements, they say. 

And they are also completely on target with regard to the political economy problem here: Many bankers oppose increased equity requirements, possibly because of a vested interest in the current systems of subsidies and compensation. But the policy goal must be a healthier banking system, rather than high returns for banks shareholders and managers, with taxpayers picking up losses and economies suffering the fallout. 

This is not extraordinary language per se you can see the same sentiments, for example, echoed throughout the new movie Inside Job (which I highly recommend, as does the reviewer for The New York Times; disclosure, one sound bite from me appears in the movie). And I have advanced similar views on this blog over the past 18 months (e.g., see this post). 

But to have the intellectual leaders of the finance profession weigh in so heavily and with such language is huge. Officials claim that they are the custodians of best practice in economics. If you criticize them on this or any other issue, they will roll their eyes implying you do not understand reality or the insights of the truly deep thinkers. 

So here are the deepest thinkers founders and mainstays of the entire field of finance finally standing up and saying: Enough of this nonsense. You may wish to pretend that keeping capital requirements low is a good idea, but you should understand that this is pretense and bad science, pure and simple. 

Remember that most productive firms in our economy are financed with equity shareholding is at the heart of the American economic model. Bankers make it sound as if something is wrong with being equity-financed, but all these big banks are publicly traded in any case. They just need to raise more equity and rely less on debt. This would not be difficult and definitely not disruptive to the nonfinancial real part of the economy. 

There is no intellectual case for the Basel process on its current basis or for the outcome that will be discussed this weekend. The Group of 20 leaders are kidding no one but themselves when they endorse this approach. 

The Group of 20 has completely failed to do what is necessary to rein in global megabanks and to make them safer. 

Listen to the leading minds of the finance profession and take corrective action now, before it is too late.