Debate Rages Over Bank Capital Requirements

As far as arcane banking regulations go, perhaps none is more polarizing right now than an agreement reached last weekend by a group of international central bankers that would require the worlds largest banks to raise their capital requirements.

The concept is pretty simple, actually. If the worlds biggest banks -- the 30 or so deemed too big to fail -- have sufficient levels of capital on hand they wont need to be bailed out by taxpayers if they get themselves into trouble by making too many bad bets.

For instance, had Bear Stearns and Lehman Brothers had enough capital in 2008 to cover their toxic assets theyd still be in the game. Instead, they had to fold and their failures set off chain reactions that nearly shut down the whole global casino. Or so the argument goes.

So, in this context, capital is simply a buffer against unexpected losses. Seems reasonable enough. But the plan has been unusually controversial, eliciting widely diverging responses from those who support the idea and those who dont.

For those who oppose the changes, forcing the banks to raise additional capital is a surefire way to push the worlds economy back into recession. For those in favor of tougher capital requirements, the central bankers proposal doesnt go nearly far enough. They say the capital requirements should be at least doubled from those agreed upon over the weekend.

Jean-Claude Trichet, president of the European Central Bank, was less hyperbolic, if somewhat obtuse. Trichet said the agreement reached Saturday by an oversight group of the Basel Committee on Banking Supervision will help address the negative externalities and moral hazard posed by systemically important banks.

In other words, the too big to fail banks wont be able to take advantage of the fact that theyre too big to fail by taking on unchecked amounts of risk knowing theyll be bailed out if they gamble wrong. They will be required to cover their own rear ends.

More to the point, though, the new requirements would ostensibly serve as a de facto punishment for growing too big in the first place and perhaps serve as a disincentive.

The agreement in Basel would require banks deemed systemically important to hold as much as 2.5% more capital than the 7%  thats already required. Banks that continue to grow could face additional capital surcharges of 1%, meaning they could be required to maintain emergency capital buffers of 10.5%.

Strident reformers wanted even tougher requirements so a compromise was reached such that the capital that is held must be top quality, namely either retained earnings or common equity. No complex derivatives, thank you very much. In addition, the new requirements wont go into effect until 2019.

Analysts predict Bank of America (NYSE:BAC), Citigroup (NYSE:C), Wells Fargo (NYSE:WFC) and JPMorgan (NYSE:JPM) are among the big U.S. banks that would have to raise the maximum amount of capital under the new proposal.

Thats where the criticism begins.

The banks themselves oppose higher capital requirements, arguing that forcing them to raise and hold onto more capital would crimp profits for shareholders, further curb their ability to lend and ultimately throw more cold water on the economic recovery.

The loudest voice in support of that argument has been Rochdale Securities analyst Dick Bove, who earlier this week called the new standards an anti-trust action and who predicted earlier that approval of the plan would lead to a second global recession.

The central bankers want to limit the growth or break up the western worlds largest banks, Bove wrote in a note to clients. Once the new regulations are out, the big banks will shrink.

Bove argues that U.S. banks are already facing hurdles to growth in the form of regulations included in the Dodd-Frank banking reform bill that passed last year in response to the recent financial crisis.

Significant aspects of that legislation target the fees that banks charge customers for such things as overdraft protection and processing debit and credit cards. With those fees shrinking, so too will banks profits, Bove predicted.

Consequently, the last thing the big U.S. banks and their shareholders need is a group of central bankers coming up with ways to further hinder their growth. Whats more, if the big banks are forced to shrink to avoid having to raise their capital requirements, who will pick up the slack in terms of the money those big banks lend? And what will that mean to the already sputtering global economic recovery?

Boves not optimistic that more rules are the answer to preventing another economic crisis: The legislators and regulators never understood what caused the financial crisis. They have never acknowledged their part in facilitating the events that led to the crisis. Now having failed miserably in meeting their responsibilities on the way in to the crisis they are perpetuating their mistakes by over-reacting by swinging in every direction without regard to the consequences. Heaven help us!! he wrote.

Gerald Epstein, an economist at the University of Massachusetts Amherst, was also critical of the Basel plan -- but for the opposite reason. The new requirements are still way too low, he said.

It is good they are trying to put extra capital charges on systemically important banks. It is also good that they are trying to develop metrics that include, for example, inter-connectedness and size, Epstein said.

But the capital requirements should be double what they are proposing, at least, he said.

And raising capital requirements is just a start. Regulators should also target limits on leverage, keep a closer eye on proprietary trading and demand more transparency in derivatives markets, he added.

Only after we get these things in place will we be able to begin to truly reform the financial system, Epstein said.

Other market watchers believe the markets should just be left alone.

Axel Merk, president of Merk Investments, said requiring banks to adhere to mark-to-market accounting would eliminate the need for meddling by bureaucrat regulators.

Mark-to-market accounting values a banks assets at whatever those assets might currently get on the open market rather than what the assets were worth when the bank obtained them. Thus, instead of pretending those assets still had value on their balance sheets, banks would have to take the necessary steps to either deleverage or raise capital to cover losses if the value of those assets plunged unexpectedly.

That way you cant wait until the hole is so big that you have to go crying to the government for a bailout, said Merk.

But regulators like to regulate.

Theyre all bureaucrats and thats what bureaucrats do. Theres a reason why the bureaucrats didnt see this thing coming and they never will, Merk concluded.