Bank Capital Standards: Basel's Leaky Levee

An international gathering of bank regulators in Basel, Switzerland solemnly announced today an increase in bank capital requirements, to which they agreed in order to prevent another worldwide credit crisis like the one in 2008. Minimum capital requirements will triple. The definition of capital will be tightened up, so somewhat elusive assets won't be treated as a safety net. It's even possible that some national regulators may impose countercyclical capital buffer requirements (i.e., rules that would obligate banks to add to their capital in good times as a further buffer against bad times). Regulators worldwide are congratulating themselves on a job well done.

There is, however, a rosy tint to all the hoopla. The new rules, called Basel III, are just a nonbinding agreement among bank supervisors. Nothing is legally binding yet. The mighty dam against financial panic that the Basel Committee announced is not necessarily as sturdy as it might seem.

Implementation Schedule in the Slow Lane. The new rules have to be adopted through whatever regulatory or legislative means would be required in each member nation, and the members have until the beginning of 2013 to begin implementing the new rules. Capital requirements are supposed to double current requirements by the end of 2017, and more than triple by the end of 2019. That's nine years from now. A lot can happen in nine years. Nine years ago, in 2001, the stock market was on an inflation-adjusted basis higher than it is today and unemployment was a lot lower. In the intervening nine years, we would have a housing boom and bust, and a crippling credit crisis. Fortunes would be made in finance, while retirements for the rest of us would be deferred. Americans in 2020 may have a safer, sounder and more stable financial system. But we have to slog through years of same old, same old to get there. In the meantime, with the economy slowing and possibly headed for another recession, we could have yet another banking crisis before we have new bank capital standards in place. (In the past nine years, we've had two recessions, so one more in the next nine years is hardly unimaginable.)

Bank Lobbying and Political Contribution Budgets Boom. Because each member nation has to go through the process of legally adopting the new rules, bank lobbyists and bank-friendly politicians can reasonably anticipate improved cash inflows for the next few years. Banks have it real good at the moment--low capital standards, implicit and explicit government guarantees, gratifyingly generous government subsidies, and only a moderate amount of flak about exceptionally handsome executive compensation. The Basel III rules will lower profits, reduce incentives to use leverage, potentially reduce or eliminate dividends (at least for some years) and, worst of all, dampen banker bonuses. Banks will use all the political influence they have to delay and soften the rules. The preceding Basel II capital requirements, which didn't exactly cover themseves with glory given that the 2007-08 financial crisis happened on their watch and resulted in the largest bank bailouts ever, were announced in 2004, delayed in 2005, and are still in the process of being implemented. Now that the regulators have reached agreement on Basel III, look for the political scrambling to begin in earnest.

Outflanking Basel III. Because of the extraordinary costs of the bank bailouts and the continuing need for federal regulators to subsidize banks, it might not be altogether surprising if the Federal Reserve and other regulators implement Basel III largely as announced. Bankers will look to skin the cat in other ways. Accounting standards can be manipulated. In 2009, bankers called in political chits to get Congress to heap organic material on regulators until they agreed to loosen up accounting rules for mortgage-backed investments (held by banks in enormous amounts). The result was that so called "mark-to-market" accounting was made more of a discretionary judgment than a requirement. What self-interested banker (and is there any other kind?), comparing the losses that would result from marking mortgage-related assets to market, to the earnings that could result from overlooking the cruel dictates of the market, would not conclude that a liberal valuation of his bonus is preferable to a conservative valuation of the bank's assets? Rigorous capital standards don't accomplish much if accounting standards allow hinky assets to be swept under the carpet.

It's possible Basel III will ultimately produce a better financial world. But don't count on it. Keep your debt levels low, your saving rate high and your hand on your wallet.

The Meaning of Fair Value Accounting

On September 15, 2006, the Financial Accounting Standards Board (the body responsible for establishing corporate accounting rules for the U.S. stock markets) adopted Statement 157, a set of rules concerning the determination of the "fair" value of an asset. This is the rule that governs the way many assets are valued, including the financial instruments that have turned toxic in the last two years. That day, the Dow Jones Industrial Average closed at 11,560.77, up 33.38 from the previous day. It achieved an intraday high of 11,661.38, or 133.99 above the previous day's close. By all indications, the stock market approved of Statement 157's impact on fair value accounting.

Today, under severe pressure from various members of Congress from both parties, the FASB issued interpretive guidance that appeared to give financial institutions more flexibility in the way they applied the fair value rules. In effect, banks were given greater latitude to avoid writedowns on assets not traded in active markets, including many toxic assets. The Dow closed at 7978.08, up 216.48. It reached an intraday high of 8,075.73, or 314.13 above the previous day's close. By all indications, the stock market approved of the rolling back of the stringency of fair value rules.

There are several conclusions one can draw: (a) the stock market is wrong at least half the time; (b) the stock market has no idea what's going on; (c) the stock market is, at the moment, manic; and (d) the stock market didn't understand the full implications of the initial adoption of Statement 157, but now has a better understanding. The correct conclusion is all of the foregoing.

Statement 157 was adopted at a time of ballooning asset values. Few people anticipated the real estate downturn, credit crunch and grizzly bear market we have today. Those that did were regarded as freeze-dried food and bottled water stockpiling Chicken Littles. Accounting rules rarely come into controversy during good times because rising asset values allow a company to look good even if the rules are stringent.

But falling asset values have the potential to expose a multitude of sins. As the financial system and economy fell on hard times, banks began to cringe over the need to mark assets down. It's easier to blame an accounting rule than writing assets down and recapitalizing a crippled bank. No bank executive was ever fired for blaming an accounting rule; nor was one ever fired for using political influence to get an accounting rule relaxed.

It's unclear whether today's interpretive changes will have the positive impact that investors seem to expect. Citigroup has already announced that it won't change its accounting even with the FASB's new guidance. To the extent that banks use the new guidance to paint a rosier picture of themselves, they may only be delaying the pain if the real estate market and economy don't rebound fairly soon. Accounting rule changes don't improve a homeowner's chances of meeting the rising payments on an adjustable rate mortgage. A laid-off worker doesn't get any more cash with which to cover monthly payments if the FASB relaxes Statement 157. Smart investors won't invest new capital in a crippled bank just because the bank has taken advantage of liberalized accounting rules to freshen up its makeup. Indeed, doing so may heighten investor suspicions that the bank's assets have a serious mold problem.

The FASB's action today may help the stock market continue a near-term rise. But if you want to know if the market has truly bottomed out and that long term recovery has commenced, look beyond the pronouncements of accounting authorities.