FDIC vice-chair says Basel III capital requirements provide illusion of safety

Basel III's capital requirements are allowing banks to present a facade of safety while taking on more and more leverage, Thomas Hoenig, vice-chairman of the Federal Deposit Insurance Corporation (FDIC), said yesterday.

In remarks to a conference of the International Association of Deposit Insurers, held in Basel, Hoenig said once regulatory capital weightings are set, banks immediately set about finding ways of reporting risk-weighted assets that are far smaller than their actual assets under management. This allows them to take on more leverage while appearing safe. "This ‘leveraging up' has served world economies poorly," Hoenig said.

By contrast, Hoenig said a leverage ratio that included only tangible assets was a much better way to restrain banks. The leverage ratio varied depending on the accounting rules used, but showed a "much smaller buffer" than what is implied by Basel III's capital ratios, he said.

Furthermore, systemically important banks in the US are much more heavily leveraged than smaller institutions, Hoenig said. Based on International Financial Reporting Standards, the FDIC estimated that the US's eight global systemically important banks (G-Sibs) had an average leverage ratio that was four percentage points lower than the 10 largest non-G-Sibs – even though their regulatory capital levels were roughly the same.

During the financial crisis, the 10 largest banks in the US reported Tier I capital ratios that averaged above 7%, while their leverage ratios averaged just 2.8%. Basel III only raises the leverage ratio to 3%, which Hoenig said had already been shown to be insufficient. "It is wrong to suggest to the public that, with so little capital, these largest firms could survive without public support should they encounter any significant economic reversals," he said.

This ‘leveraging up' has served world economies poorly

The risk-weightings in the Basel III framework further served to distort markets, Hoenig said: "The result is often to artificially favour one group of assets over another." This in turn led to overinvestment in assets such as sovereign debt – assigned a zero risk weight – "discounting the real risk they presented and playing an important role in increasing it," he said.

A ‘more realistic' standard

Hoenig added his voice to a rising number of critics, who argue that the Basel III capital ratios are overly complex and too easy for banks to get around. Recently a director at the FDIC, Jeremiah Norton, and the Bank of England's executive director for financial stability, Andrew Haldane, both challenged the capital ratios and advocated a higher leverage ratio instead.

Hoenig said the capital requirements were flawed because they tried to do too much, based on too little information. "All of the Basel capital accords, including the proposed Basel III, look backward and then attempt to assign risk weights into the future," he said. "It doesn't work."

By contrast, the leverage ratio, when based on tangible assets, provided a "simpler, more direct insight" into the amount of loss-absorbing capital a bank held.

More difficult, Hoenig said, was determining what level to set the leverage ratio at. Although he did not suggest a specific number, he pointed to an "increasing body of research" that suggested leverage ratios should be "much higher than they currently are". He noted that before the Federal Reserve was set up in 1913, it was common for banks to have leverage ratios between 13 and 16%, enforced only by market discipline.

Hoenig stressed, however, that he did not think capital ratios should be scrapped, instead suggesting they should be the ‘backstop' to the leverage ratio. This would allow regulators to ensure that banks were not concentrating assets in areas that increased the vulnerability of the balance sheet, he said.