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Another reason banks need more equity: They tend to have less than they claim

protest outsideof the FDIC takeover ofIndyMac Bank, make the one year anniversary at City Irvine, Monday, July 13, 2009. (AP Photo/Nick Ut)
AP Photo/Nick Ut
As IndyMac’s customers know, bank failure isn’t just something that happens in Cyprus.
  • Tim Fernholz
By Tim Fernholz

Senior reporter

This article is more than 2 years old.

We reported yesterday on the argument by Stanford University professor Anat Admati that major US and European banks have something in common with Cyprus’ failed banks—not enough equity. And some readers have responded: Don’t regulators that keep an eye on how risky a bank’s assets are, and the Federal Deposit Insurance Corporation (FDIC) which can resolve failing banks, do the job of making sure banks are safe?

Let’s ask the former chair of the FDIC, Sheila Bair, who shut down IndyMac, a US bank the size of the failed Bank of Cyprus, in 2008. In a new Wall Street Journal article, she argues that banks look safer than they are (paywall) because of how regulators weigh the riskiness of assets:

For instance, as part of the Federal Reserve’s recent stress test, the Bank of America reported to the Federal Reserve that its capital ratio is 11.4%. But that was a measure of the bank’s common equity as a percentage of the assets it holds as weighted by their risk—which is much less than the value of these assets according to accounting rules. Take out the risk-weighting adjustment, and its capital ratio falls to 7.8%.

The article is worth reading for the catalogue of ways banks can reduce their exposure. They’re allowed to rate derivatives as safer than collateralized business loans. They have incentives to lend to each other, despite worries that the financial system is too inter-connected. Sovereign debt—including debt from shaky countries on the euro-zone periphery—gets special treatment by local regulators. None of it will gladden your heart.

Risk-weighting also softens the force of the new Basel III capital standards that banks are complaining about. We reported yesterday that Basel III requires banks to hold a 7% ratio of common equity to assets, but Admati points out in an email that it’s in fact only 3%. (She thinks it should be more like 20%-30%.) The 7% figure is the ratio of common equity to risk-weighted assets. To put that in perspective, the troubled Greek debt that brought down the Cypriot financial system had zero risk-weight because it was sovereign debt.

Resolution—the tools governments use to shut down failing banks with a minimum of social cost—is clearly important. Some combination of the financial crisis and the reforms that followed has convinced markets that banks are more likely to fail now than they were before 2008. That should reduce the implicit government support that makes it easy for the largest banks to borrow more cheaply than they otherwise would by increasing risk to bank creditors.

But resolution comes into play only if regulators think a bank is insolvent—if it has exhausted its equity loss buffer. When that happens, resolution won’t protect uninsured deposits, just as it didn’t in Cyprus. Indeed, from 2008 to 2012, 465 US banks failed, and in 409 cases, the FDIC required 41% of uninsured deposits to wind down the banks, according to a recent JP Morgan note.

It’s worth noting, too, that safety isn’t the only reason why banks should have more equity. Admati, Bair and others argue that it will also improve lending. Banks with more capital have made more loans since the crisis. By that logic, higher equity wouldn’t just be a boon for bank safety; it could help spark economic growth. And in any case, merely “not failing” is a pretty low bar to set for a financial system.

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