When JPMorgan Chase & Co. Chief Executive Officer Jamie Dimon appeared before the Financial Crisis Inquiry Commission, he testified that he told his daughter a financial crisis is something that happens every five to seven years. That observation turned out to be overly optimistic.
Once again, the world’s financial leaders are cobbling together a rescue package to avert the potential failure of highly leveraged financial institutions holding assets of questionable value. This time, the epicenter of the crisis is Europe, not the U.S., and the assets at issue are not toxic mortgages and derivatives, but plain vanilla government bonds. How could the latest round of global financial turmoil be triggered by something as simple as government debt?
The answer is that financial regulators, especially in Europe, became enamored with complex, “risk-based” capital standards. The less risky an investment supposedly was, the less capital a financial institution needed to hold. The capital standards embodied in Basel II — a compact among regulators, largely from the Group of 20 countries — allowed big banks to rely on their own risk models when deciding how much capital they needed to underpin their borrowing. The banks embraced this approach — after all, what bankers wouldn’t want to set their own rules?
These risk-based standards played a role in the 2008 financial crisis, allowing major financial firms to hold “safe” mortgage securities with scant capital. Today’s European crisis has again shown the flaws of this approach.
Under the Basel framework, government debt of developed countries was assigned a risk weight of zero. That means that with $1 of capital, major banks could hold unlimited amounts of the sovereign debt of those nations, while satisfying the risk- based capital standard’s credit test. Partly because of the Basel rules, European banks stuffed themselves to the gills with government bonds.
The Basel rules said that Greek sovereign debt, which will now be exchanged by banks for assets at more than a 70 percent loss on the face value, had zero credit risk.
This approach defied common sense, but it reflected the hubris of regulators and bankers who believed that risks could always be quantified and controlled, and that the self- preservation instincts of bankers would somehow protect the public interest.
Governments liked the Basel rules because they lowered the cost of issuing sovereign debt by providing eager buyers. Big banks liked the rules because they could increase their return on equity, reaping large profits by making highly leveraged bets on government bonds. Indeed, why go through all the trouble of making a small business loan, which you can leverage at only 12- to-1 under the risk-based standards, when you can make a 50-to-1 wager on government bonds?
Yet, the easy money that flows from high leverage in good times can turn disastrous in tough times. From the demise of Long-Term Capital Management LP in 1998, to the near collapse of the financial system in 2008, to the implosion of MF Global Holdings Ltd. last year, the pernicious effects of excessive leverage have been on full display.
There’s a smarter and safer way to set capital standards. Since the passage of the Federal Deposit Insurance Corporation Improvement Act of 1991 and with the leadership of the FDIC, regulated U.S. banks have been held to a simple capital standard, known as the leverage ratio, requiring them to hold $1 in capital for every $20 in assets.
Simpler Is Better
Partly due to that standard, many banks weathered the financial storm better than did the investment banks, which were not subject to the rule and hurtled toward failure in 2008. Sometimes, simpler is better.
What’s needed are tougher, more transparent capital standards. The new Dodd-Frank law requires that regulators subject bank holding companies — JPMorgan, Citigroup Inc. and the like — to leverage rules that encompass off-balance-sheet activities, which contributed significantly to the 2008 crisis. And in 2010, the Basel Committee announced that, in the future, it would test a non-risk-based leverage ratio of 3 percent of total assets, including off-balance-sheet derivatives and commitments.
While this is a step in the right direction, history has proven that 33-to-1 leverage is too much. As U.S. bank regulators consider the adoption of risk-based capital rules compatible with the Basel framework, they should make sure that any such rules are supplementary to, and not in lieu of, the strict and simple leverage ratio of no greater than 20-to-1.
As important, they should ensure that the type of capital permitted in such a ratio is restricted to tangible common equity — in other words, real loss-absorbing capital, not debt masquerading as equity.
These standards will allow banks to make fair profits, while protecting the public. And who knows, they might even encourage banks to make loans to build businesses and create jobs, rather than place highly leveraged bets that put their firms and the financial system in peril.