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Ask a bank CEO which capital standards his regulators care most about, and what minimum levels they’re insisting on, and he’ll look as if you’d asked him to count to 100 in Mandarin. He won’t have a clue.

But you can’t blame the poor guy. These days, banks don’t know what capital standards they’re supposed to be operating under. Yes, regulators have published official numbers. But in the wake of the financial crisis, they’re also whispering new, much higher, “guidance” that they’re “encouraging” bankers to follow. What’s a banker supposed to do?

This schizophrenic regulatory approach, which has been adopted by the OCC, the FDIC, and the Fed, makes no sense. It inhibits bank lending, and is unfair to bankers and capital market participants. If not reversed, regulators’ new approach will have the unintended consequence of making bank credit both more expensive and harder to get. Plus, it will put U.S. banks at a competitive disadvantage to foreign banks. None of these effects, you will notice, are good.

Instead, the administration should either stick to the existing capital standards or, if it believes current standards inadequate, promulgate new ones. But seat-of-the-pants bank regulation is neither good for the banking nor the economy overall.

And it’s not as if the existing standards are capricious or were randomly arrived at. Just the reverse; they’re the product of an enormous amount of painstaking work. In 1998, after years of intense negotiation, the industrialized nations agreed on the Basel accords, a universal capital standards for banks. The U.S. adopted the accords the following year; two key ratios are at their core:

Tier I Capital. The Tier I capital ratio is shareholders’ equity as a percentage of risk-weighted assets. U.S. regulators set 4% as a minimum, and 6% for a bank to be considered “well-capitalized.”

Total Capital. Total capital is Tier I capital, plus subordinated debt, plus loan loss reserve (within a limit) as a percentage of risk-weighted assets. The minimum for U.S. banks is 8% minimum, with a 10% minimum for “well-capitalized.”

It was of course no small task for the industrial nations to reach unanimous agreement regarding the regulation of an industry so vital to economic growth. Inevitably, no one was overly pleased with the final result. The U.S. in particular wanted to mandate higher minimum standards, but the Europeans and the Japanese felt that higher standards would unduly restrict credit creation and economic growth in their countries. Hence, the U.S. adopted the Tier I and Total Capital ratios, but required U.S. banks maintain higher levels than those prescribed in the final agreement.

In addition, the U.S. pushed for some simple overall limit on leverage, but failed to win enough support. So U.S. bank regulators went ahead and adopted a third regulatory capital ratio, the leverage ratio, which is simply shareholders equity as a percentage of assets. They set the minimum at 3% and well-capitalized at 5%.

My point in going through all this is that a lot of careful thought and work has already gone into what it means to be well-capitalized.

Which brings us to today. U.S. bank regulators have adopted three primary measures of capital adequacy (Tier I, Total, and Leverage) and have published official targets for each. But as noted, regulators are now ignoring the minimums they’ve posted, have dreamt up entirely new ratios ad hoc, and are insisting banks maintain levels much higher than the official levels. This is simply wrong!

The administration and the Fed seem to think the capital levels of the world’s banks are too low. As Tim Geithner said in early September, “A principal lesson of the recent crisis is that stronger, higher capital requirements for banking firms are absolutely essential.”

So the U.S., aiming for a quickie patch-up job, is working with other countries to not just come up with new and higher capital standards, but to strengthen regulation that deals with (take a deep breath) a) bank liquidity, b) risk management, c) incentive compensation, and d) consumer protection. The U.S. has set a goal of yearend 2010 for new agreements in these areas.

Good luck with that deadline! It took a decade to agree on the first set of capital standards (and then another decade to agree on their revision). Do you really think these countries can reach an agreement on capital, liquidity, risk, and compensation and consumer protection in 12 months? And if they can, do you think the agreement will be the product of thoughtful, prudent negotiation, as opposed to a grab-bag of half-baked, knee-jerk prescriptions? My answers are no, and no.

But that unrealistic deadline isn’t what bothers me the most. Even worse is that, in the meantime, U.S. bank regulators seem to be making up minimum capital ratio requirements, that vary from bank to bank, as they go along. It is a picture of total arbitrariness, the exact opposite of what smart regulation is supposed to be about.

The administration’s regulators don’t want to officially raise capital standards on banks in the midst of a recession, for fear of (justified) criticism that the move would restrict credit creation. For that matter, regulators don’t want to impose higher standards unilaterally, for fear of (again, justified) criticism they’d be putting U.S. banks at a competitive disadvantage globally.

But regulators are doing all this anyway, only unofficially. Worse, they are heightening uncertainty all the more by treating individual institutions differently from one another.

The Obama administration’s current regulatory approach to bank capital is capricious, unfair, and destructive to the country’s credit system and economic health. It should be changed! The administration wants banks to lend more. The best way for it to do get them to do that would be to clarify the rules banks should be operating under.

Source: Confusion Reigns About Banks' Minimum Capital Requirements