Bankers don’t like the new rules that international regulators are drawing up. Jamie Dimon, chief executive officer of JPMorgan Chase & Co., has gone so far as to call them “anti-American,” suggesting that the U.S. break with global regulators and go its own way.
Dimon is absolutely right, but for the wrong reasons. The new banking rules, known as Basel III, are too weak, not too strong.
Basel III represents the third attempt in about two decades to address one of the biggest threats to the global economy: The tendency of financial institutions to go bankrupt during bad times. Among other reforms, the rules require banks to finance their activities with more equity (or capital) as opposed to debt. The equity helps guarantee that the bank’s shareholders will absorb any losses, instead of turning to taxpayers for bailouts.
Despite Dimon’s complaints, the capital requirements aren’t terribly burdensome. For the biggest banks, they amount to somewhere between 3 percent and 5 percent of assets, similar to putting $3,000 to $5,000 down on a $100,000 house. In the convoluted math of Basel (more on this below), that’s the equivalent of a risk-weighted capital ratio of 10 percent.
Dimon and other bankers say 10 percent is too much. They warn that the need to raise more equity will increase their costs, forcing them to charge higher interest rates on loans, with dire repercussions for the economy.
Their argument is specious at best. Even assuming that banks’ costs would rise (an assertion many economists question), there are other ways to offset the added costs. Consider bankers’ pay. Average U.S. wages in finance are about 70 percent higher than in other industries. Erasing that compensation gap -- it didn’t exist 30 years ago -- would cut the typical bank’s operating expenses by almost 20 percent. That’s just about enough to raise the capital ratio from 5 percent to 10 percent without increasing lending rates, and without impairing shareholder profits.
To our minds, the strongest argument against Basel is that it doesn’t go far enough. The best research available has found that much higher capital ratios would be good for the economy because the benefit of reducing the frequency of financial disasters far outweighs any costs. The optimal risk-weighted capital ratio would be about 20 percent, equivalent to equity of 7 percent to 10 percent of total assets, or double the level in Basel III. What’s more, economists see little risk to growth if regulators err on the high side, while the dangers of having too little capital are painfully apparent.
Another argument against Basel is that it creates perverse incentives in the way it calculates capital. Instead of simply dividing a bank’s equity by its total assets, the Basel rules assign each asset a weight that is supposed to correspond to its risk. Government bonds, for example, have a zero weight, as if they had no risk at all. This feature makes them very attractive, and helped turn Europe’s debt problems into a global crisis by encouraging banks to invest heavily in the high-yielding debt issued by Greece and other countries.
The risk-weighting system is also far too complex and too easily manipulated to provide a reliable picture of how much capital a bank really has. For a large bank such as JPMorgan, coming up with a risk-weighted ratio requires sorting assets into more than 200,000 different buckets. Even unintentional errors can skew reported capital ratios by several percentage points. That’s a problem when the starting point is only 10 percent.
The flaws in the Basel rules have led Britain, which has one of the world’s largest concentrations of big banks, to create its own, more stringent requirements. Under a plan the U.K.’s Conservative-led government intends to adopt, big banks must have loss-absorbing capacity -- consisting of equity and debt that converts into equity in times of stress -- of at least 17 percent and as much as 20 percent.
The U.S. would do well to follow the U.K.’s example and impose a 20 percent risk-weighted capital requirement for the biggest banks. To make sure they’re not gaming the system, their equity should also exceed 10 percent of total assets. This would be anathema to Dimon and other bankers, but it would prevent them from taking the kinds of risks that can result in big bills for taxpayers and economic misery for millions of families.
To contact the senior editor responsible for Bloomberg View’s editorials: David Shipley at firstname.lastname@example.org.