Capital Car Wreck

Most of the coverage surrounding the G-20 ministers of finance’s Sept. 5 correspondences on its plans in advance of the big Pittsburgh Summit touted the group’s plans to shore up capital requirements for banks.

To me, the opposite was true.

The G-20 has all but tipped its hand in favor of the status quo on capital requirements. It gives me small consolation to know Simon Johnson of the Baseline Scenario blog agrees with my sentiments.

The matter of capital requirements in the G-20’s “Declaration on Further Steps to Strengthen the Financial System” issued last week boils down to this amorphous statement on the G-20’s intentions:

Rapid progress in developing stronger prudential regulation by: requiring banks to hold more and better quality capital once recovery is assured; introducing countercyclical buffers; developing a leverage ratio as an element of the Basel framework; an international set of minimum quantitative standards for high quality liquidity; continuing to improve risk capture in the Basel II framework; accelerating work to develop macro-prudential tools; and exploring the possible role of contingent capital. We call on banks to retain a greater proportion of current profits to build capital, where needed, to support lending.

First, as I have written previously, words mean nothing when it comes to capital requirements. It’s the numbers that count, and there are no numbers here. Second, by my read, the G-20 is continuing its allegiance to the Basel II accords, albeit with the intent of “improving” them. This may come as a shock, but Basel II still requires the same amount of Tier 1 capital as it did before the credit crisis: 8%. The US Treasury Department, through its various initiatives, have effectively increased the Tier 1 capital requirements of all US banks over 10% — with the capital ratios of smaller banks skirting 12%.

Just yesterday, the Bank for International Settlements, which administers the Basel II standard, came out with a “Comprehensive Response to the Global Banking Crisis.” Its No. 1 measure “to strengthen the regulation of the banking sector” was, “Raise the quality, consistency and transparency of the Tier 1 capital base.” While there is nothing specific in the “Comprehensive Response” that says the Basel II capital requirements will increase beyond 8%, Nout Wellink, chairman of the Basel Committee and president of the Netherlands Bank, said in a statemtent that “these measures will result over time in higher capital and liquidity requirements and less leverage in the banking system, less procyclicality, greater banking sector resilience to stress and strong incentives to ensure that compensation practices are properly aligned with long-term performance and prudent risk-taking.”

Well, we’ll see. I certainly am not encouraged by the Basel framework. We are just days from the first anniversary of the Lehman Brothers meltdown and it’s only now that we get a declaration from the Basel Committee that it will increase capital requirements. Not impressive. And with its recent communiqués, the G-20 is going along with this lackluster reform of capital requirements. The G-20 would be better off ditching Basel II and taking bolder steps that re-imagine how banks should be capitalized. Anyone think that will happen?