Even as we and other commentators have noted the underlying weakness of major bank balance sheets, which have been propped up by asset-price-flattering super low interest rates and regulatory forbearance, we still witness the unseemly spectacle of major banks keen to leverage up again. The current ruse is raising dividends to shareholders, a move the Fed seems likely to approve. Anat Admati reminded us in the Financial Times on Wednesday that we are about to repeat the mistakes of the crisis:
Paying dividends helps banks maintain excessive leverage. A typical bank funds over 95 per cent of its investments with debt and less than 5 per cent with equity. A small drop in asset values can lead to distress and possible insolvency. We have seen that furious “deleveraging” by any highly leveraged and interconnected bank can start a crisis…
The Basel III reforms agreed last year set minimum bank equity between 4.5 per cent and 7 per cent of “risk-weighted assets”, which are significantly smaller than total assets for most banks. Triple A-rated assets require little or no equity capital. The system of risk weights established by Basel II, which distorts banks’ investments towards favourably treated assets, was mostly maintained. Under Basel III, the ratio of equity to total assets can be as low as 3 per cent.
These equity requirements are dangerously low. Significantly increasing banks’ equity funding would provide many benefits to the economy, at little social cost.
Our Richard Smith has provided a series of posts analyzing the many shortcomings of Basel III (see here, here, here and here); below is his drive-by shooting:
Here are my main gripes:
Valuation: the capital ratios mean nothing if the assets are overvalued.