Regulatory Reform: The New Geithner Plan

by: Tom Lindmark

Among the problems that crop up with the innumerable proposals for reregulating the banks on the blogosphere and in the MSM is that they too often ignore the political realities that have to be factored into any workable plan. Not that many don’t have merit, just that they are practically impossible.

The administration and Treasury Secretary, Tim Geithner, in particular don’t have that luxury. They have to come up with something that will get through Congress, that won’t attempt to reconfigure an entire financial system in a year or less and that dovetails with the regulatory schemes of other countries.

In that vein, Geithner has introduced his proposal for regulatory reform:

1) capital requirements that are designed to protect the stability of the financial system and individual banks. In other words, reduce the ability of banks to “accumulate” risk during boom times by requiring them to hold more capital during boom times.

2) all banks to hold more capital and the biggest banks to hold even more capital than that. No large financial companies should be able to evade these limits.

3) a greater emphasis on the quality of capital. Higher quality capital means it is better able to absorb losses. Voting common equity should represent a large majority of a bank’s tier 1 capital.

4) risk-based capital requirements that reflect the risk of a bank’s exposures. Reduce the reliance on a bank’s internal models to dictate what their capital requirements should be. Regulatory capital ratios should reflect more accurate information about the health of a bank.

5) a way of addressing the huge problem caused by procyclicality, which essentially means that banks have little capital to spare when times are bad because they were able to hold less capital when times are good. This has been a huge issue that policy makers have struggled with for years, and Mr. Geithner has several pages worth of ideas on this front.

6) a “simple, non-risk-based leverage constraint.” G-20 leaders have agreed to this in principle, but it has not yet been implemented. It would make it harder for banks to game risk-based capital standards because there would be a capital floor they couldn’t fall below.

7) a conservative and explicit liquidity standard. This is something regulators have been emphasizing in the last year and many consider as important as capital standards.

8) ensuring that tougher capital requirements don’t allow firms to migrate to places where such capital requirements don’t exist. In other words, keep the playing field balanced and don’t allow huge risks to buildup in the system outside of regulation.

There seems to me to be a lot to like in these proposals. Focusing on capital and liquidity get to the nub of the problem we’re fighting through right now. The banks were undercapitalized and they fundamentally didn’t understand the extent of the risks that they had assumed. When the quality of their assets was revealed to be much less than they assumed, their balance sheets weren’t able to withstand the hits needed in order to recognize the quality of their assets.

Geithner is, I think, going about this in the right way. There is no magic bullet that is going to ensure that banks don’t again misjudge risk. There in the business of taking it and, inevitably, will make bad decisions in the future. Key to preventing a recurrence of this last episode is to make sure they have the capital to absorb their mistakes.

Now all this looks good on paper but the key is going to getting enough people on board to implement meaningful capital requirements. The industry will go to the barricades to fight against anything that amounts to a more than a token increase in the amount of capital they required to maintain as it strikes at the heart of their profitability. Their Congressional enablers can be expected to line up behind them and even the Europeans are looking a bit shaky.

The French, German and British authorities are focusing their attention on salaries and bonuses. While it plays well to their political constituencies, excessive compensation was not, no matter how reprehensible it may seem, the cause of the financial crisis. The crisis was not born of bankers who chased bonuses at all costs and practically destroyed their industry in the process, rather it arose from incompetent risk assessment.

Curbing bonuses is not going to prevent the next panic and more importantly it is not going to prepare the industry to cope with the next panic. Geithner’s plan has elements that will give us a better shot at doing just that.

Moreover, Geithner’s plan carries elements that could well force the banks via market forces to back off on compensation. As I wrote in a post several weeks ago if you increase capital requirements, the banks are going to have to renegotiate with their shareholders the split of profits. A larger capital requirement implies lower profitability. Since bank investors are going to continue to demand a certain return on their investment, any diminution in overall profitability should cause the banks to have a smaller bucket from which to pay bonuses. They can try and maintain the bonus pool but at least that discussion will take place in the private market and not come down as dictates from some political Mount Olympus.

It’s important for the politicians to get this one right. I don’t place a lot of faith in that coming to pass.

More: here and here