Give a bank an inch…

I’ve long admired Thomas Hoenig’s habit of telling it like it is. Hoenig, former president of the Kansas City Fed and current board member of the FDIC, was at it again this week.

The Wall Street Journal reports on Hoenig’s objections to new international banking regulations known as Basel III:

In June, U.S. regulators in published draft capital requirements to comply with the Basel III standards. While bankers have been up in arms about the proposal, arguing that it will harm the economy, Mr. Hoenig argues that the rules should be rejected because they are too complex and rely on models that are subjective.

Bankers “will delegate the task of compliance to technical experts, and the most brazen and connected banks with the smartest experts will game the system,” he said. The rules use “highly arcane formulas, suggesting more insight and accuracy than can possibly be achieved.”

Here’s why Hoenig might be right.

Basel III, and its precursors Basel II and Basel I, were created by the Basel Committee on Banking Supervision. This is a Switzerland-based regulatory body that was established in 1974 by the central bank governors of 10 major nations. It has no formal treaty assuring its existence, nor does it issue binding regulation. It’s actually just an informal forum. Yet it’s also one of the world’s most credible multilateral institutions because it has largely succeeded in creating a set of common regulations that’s now applied to banks all around the world.

Hoenig is critical because Basel II and III have allowed the largest and most sophisticated banks to use their own computer models to determine how risky their assets are, and therefore how much capital they must keep on hand to cover unexpected losses. This is like allowing each driver to use his own model to calculate what a “mile” is when trying to keep to the speed limit. Sure, the models would have to be approved by each country’s banking regulator before they can be used. Yet this might still allow for an unacceptable amount of latitude — especially given the bank-induced trauma from which the global economy is still recovering. Rest assured — the largest, most well-funded banks will choose a model that lets them escape with holding as little capital as possible. While the underfunded and overwhelmed regulators will, as usual, remain several steps behind.

Mr. Hoenig said the Basel rules should be replaced with a more simple formula of the ratio of “tangible equity” to “tangible assets.” This would measure a bank’s equity without goodwill, tax assets or other accounting entries. Tangible assets include a bank’s assets minus intangibles.

Mr. Hoenig’s measurement, unlike the Basel rules, wouldn’t rely on banks to measure the riskiness of their assets.

“This simpler but fundamentally stronger measure reflects in clear terms the losses that a bank can absorb before it fails and regardless of how risks shift,” Mr. Hoenig said.

Listen to the man.

Tags: Basel III, Thomas Hoenig

Category: Regulation