PrefBlog

Treasury announced a bank capitalization wish-list last week prior to the G-20 London meeting.

Now, the Bank for International Settlements has announced that most negotiation points will be granted. All this has obviously been orchestrated and was agreed long before the G-20 ministers got on their planes to London:

The Central Bank Governors and Heads of Supervision reached agreement on the following key measures to strengthen the regulation of the banking sector:

• •Raise the quality, consistency and transparency of the Tier 1 capital base. The predominant form of Tier 1 capital must be common shares and retained earnings. Appropriate principles will be developed for non-joint stock companies to ensure they hold comparable levels of high quality Tier 1 capital. Moreover, deductions and prudential filters will be harmonised internationally and generally applied at the level of common equity or its equivalent in the case of non-joint stock companies. Finally, all components of the capital base will be fully disclosed.
• •Introduce a leverage ratio as a supplementary measure to the Basel II risk-based framework with a view to migrating to a Pillar 1 treatment based on appropriate review and calibration. To ensure comparability, the details of the leverage ratio will be harmonised internationally, fully adjusting for differences in accounting.
• •Introduce a minimum global standard for funding liquidity that includes a stressed liquidity coverage ratio requirement, underpinned by a longer-term structural liquidity ratio.
• •Introduce a framework for countercyclical capital buffers above the minimum requirement. The framework will include capital conservation measures such as constraints on capital distributions. The Basel Committee will review an appropriate set of indicators, such as earnings and credit-based variables, as a way to condition the build up and release of capital buffers. In addition, the Committee will promote more forward-looking provisions based on expected losses.
• •Issue recommendations to reduce the systemic risk associated with the resolution of cross-border banks.

The Committee will also assess the need for a capital surcharge to mitigate the risk of systemic banks.

The Basel Committee will issue concrete proposals on these measures by the end of this year. It will carry out an impact assessment at the beginning of next year, with calibration of the new requirements to be completed by end-2010. Appropriate implementation standards will be developed to ensure a phase-in of these new measures that does not impede the recovery of the real economy. Government injections will be grandfathered.

The interesting parts are the elements that are on Treasury’s wish list but are not incorporated into this announcement:

Core Principle #1: Capital requirements should be designed to protect the stability of the financial system (as well as the solvency of individual banking firms).

This one is addressed, a little, through the non-bulletted committment to “assess the need for a capital surcharge to mitigate the risk of systemic banks.” I am glad to see that BIS is leaning towards PrefBlog’s recommendation, rather than Geithner’s. What does Geithner know, anyway?

Core Principle #2: Capital requirements for all banking firms should be higher, and capital requirements for Tier 1 FHCs should be higher than capital requirements for other banking firms.

See above for increased emphasis on systemic banks – note that there is nothing in the BIS release that indicates agreement on a need to segregate “Tier 1 FHC’s” from other banks.

Core Principle #3: The regulatory capital framework should put greater emphasis on higher quality forms of capital.

This is addressed in the first bulletted point. It seems to me that to avoid confusion – and, perhaps, to ensure that the “Third Pillar” of the investment community is encouraged to follow this emphasis – they will need to define a new capital ratio, the “Tangible Common Equity Ratio” or something.

Core Principle #4: Risk-based capital requirements should be a function of the relative risk of a banking firm’s exposures, and risk-based capital ratios should better reflect a banking firm’s current financial condition.

This was just ‘let’s do it better next time’ boiler-plate; while not particularly significant, it is interesting none-the-less that the issue is not mentioned by BIS.

Core Principle #5: The procyclicality of the regulatory capital and accounting regimes should be reduced and consideration should be given to introducing countercyclical elements into the regulatory capital regime.

Addressed by the fourth bulletted point.

Core Principle #6: Banking firms should be subject to a simple, non-risk-based leverage constraint.

Addressed by the second bulletted point. This is probably the single most important committment to improvement in the release.

Core Principle #7: Banking firms should be subject to a conservative, explicit liquidity standard.

Addressed by the third bulletted point. I am disappointed to see that the favoured treatment for paper issued by other banks in the risk-weighting process is not being addressed.

Core Principle #8: Stricter capital requirements for the banking system should not result in the re-emergence of an under-regulated non-bank financial sector that poses a threat to financial stability.

I’m glad to see that this principle is not addressed in the BIS release – it is the only Treasury proposal with which I have serious philosophical problems.

I don’t like the second bullet of the last bit of the BIS release:

The Group of Governors and Heads of Supervision endorsed the following principles to guide supervisors in the transition to a higher level and quality of capital in the banking system:

• •Building on the framework for countercyclical capital buffers, supervisors should require banks to strengthen their capital base through a combination of capital conservation measures, including actions to limit excessive dividend payments, share buybacks and compensation.
• •Compensation should be aligned with prudent risk-taking and long-term, sustainable performance, building on the Financial Stability Board (FSB) sound compensation principles.
• •Banks will be required to move expeditiously to raise the level and quality of capital to the new standards, but in a manner that promotes stability of national banking systems and the broader economy.

Supervisors will ensure that the capital plans for the banks in their jurisdiction are consistent with these principles.

Compensation is none of the regulator’s damn business. If they want to regulate risk, they can regulate risk, no problem; but micro-management will only lead to problems. Unfortunately, the regulators have won the public relations war and diverted attention from their own inadequacy towards the memes of “sloppy credit raters” and “greedy bankers”.