Regulators rightly want to remedy a serious flaw in the financial system: The complexity of bank capital requirements has made them vulnerable to manipulation. In the rush to embrace simplicity, however, policymakers could inadvertently make safe investments unattractive for banks.
At issue is the risk-weighted capital ratio, a measure regulators have long used to assess banks’ soundness. Instead of simply dividing equity by total assets, it assigns each asset a weight that is supposed to correspond to its risk. The idea is that $10 in capital might be too little to absorb potential losses on $200 in subprime mortgage loans, but more than enough for the same amount in U.S. government bonds. The safer a bank’s assets are judged to be, the higher its ratio.
The approach hasn’t worked well, because the risks of some assets have been badly underestimated. That’s not surprising, given that regulators have often relied on banks to do the measurement using their own internal models. Bank executives typically prefer lower capital levels than regulators would judge sufficient, and thus are motivated to understate risks.
Regulators have incentive problems, too. It is politically incorrect to announce that the sovereign debts of some nations, especially their own, are riskier than others. Hence, regulators assign relatively undifferentiated and unrealistically low risk weights to government debt.
To mitigate the shortfalls of risk weighting, regulators are working on new leverage rules that would set a floor on capital as a percentage of assets, regardless of their riskiness. A proposed rule in the U.S. would set the minimum at 5 percent for large banking holding companies. Global regulators, under the auspices of the Basel Committee on Banking Supervision, are also considering a new international minimum.
The U.S. leverage rule would require some banks to raise more capital -- meaning that the new rule would replace the risk-weighted ratio as the binding constraint. Raising bank capital levels is a good idea, but doing it this way could have an unintended effect: Banks would be able to take on more risk for the same amount of capital merely by shifting to riskier assets.