Do Banks Need Tighter Regulations For Capital?

The answer to this might seem obvious these days. But with banks and the economy feeling the heat of the subprime mortgage mess, of course Congress and the Fed are weighing in. The real question, however, isn't regulation in of itself but what KIND.

Few anticipated that the value of mortgage loans, traditionally a mainstay of banking, would take a nosedive. As Fed Vice Chairman Donald Kohn told the Senate Banking Committee this week, "I don't know that we fully appreciated all these risks out there. I'm not sure anybody did."

Tuesday's Wall St. Journal included an article on the possible effects of Basel II (B2), proposed international standards for risk capital that - in theory - should help prevent the kind of massive write-downs by banks.

First, a little primer on risk capital: It's the amount of capital that regulators require banks to hold against their total assets. Typically it's based on a % of assets, which are categorized in terms of risk. So the riskier the asset, the more capital a bank has to hold aside in a reserve fund.

Why B2? One reason is set international standards for capital. Because each country has different accounting standards and capital markets, what might be considered 'equity capital' in Germany may not hold the same in the US. Keeping everyone on the same playing field would enable US banks to compete better globally.

Another reason is to allow the banks to assess risk levels specific to the type of asset, taking into account their own risk assessments and the opinions of credit rating agencies (i.e. Moody's, S&P), rather than adhere to regulatory guidelines that are more standard. After all, who would know better than the banks as it's their own business? Furthermore, B2 requires a safety net of capital for assets held off balance sheet. Theoretically B2 would enable banks to assess their capital reserves in a way that better reflects the underlying risk if their assets.

Some European banks have recently implemented B2 compliance; US banks have a couple of years to phase it in. The concern is that under B2 banks might underestimate how much of a capital cushion they'll need to absorb future losses. Another issue is the reliance on the opinions of credit rating agencies. Oh, and there’s the point that B2 doesn’t require as much monitoring of liquidity as US regulators would like.

Even under current US regulatory capital standards, banks are having trouble. This has Congress and regulators concerned that B2 standards would only exacerbate the situation, calling for further tinkering before banks implement the new program.

So here's what happened: banks valued their mortgage holdings as safer investments, only to find out the market didn't agree. Oops.

Ironically, hedge funds, that were previously thought of as a possible cause of the next big market bust, are lightly regulated in this regard. Of course many of them are feeling the same heat, so it calls into question the overall effectiveness of our current bank regulatory environment. Perhaps Congress and the SEC will pick up on this.

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