"Strengthening Global Capital
An Opportunity Not To Be Lost"
Remarks by
FDIC Vice Chairman Thomas M. Hoenig
To the
22nd Annual Risk USA Conference,
New York, NY
November 9, 2016
Introduction
Basel III is scheduled to be finalized by year-end and presented to top regulators and
central bankers for approval in early 2017. The original goals of the six-year-long effort
were to "reduce the complexity of the regulatory framework and improve comparability"
and "address excessive variability in the capital requirements for credit risk."1 These
goals are laudable.
Unfortunately, as memory of the 2008 financial crisis has waned, the exercise has
added a third objective: ensuring that the final calibration of the Basel III framework not
significantly increase overall capital requirements.2 Should this occur, it would truly
represent an opportunity lost. Instead of strengthening the foundation of the global
financial system, as was intended with the original goals, Basel III would legitimize the
inadequate status quo and undermine the long-run objective of real financial stability.
In my remarks today I will discuss key factors that are at the core of the on-going debate
over what defines adequate capital. First, I will discuss the controversy over alternative
measurements for judging adequate capital. Simply stated, most measurements are too
complicated, set too low, and often vary by jurisdiction in ways that weaken global
financial stability. Second, relying only on public information, I will note changes that the
Basel Committee appears to be considering that will weaken current standards and why
these changes are ill-advised. Third, I will reiterate my concerns regarding Total Loss-
Absorbing Capacity (TLAC) and its use as a means to justify lower levels of capital and
require firms to issue more debt.
Capital Adequacy
Capital levels are reported as a ratio, with equity capital amounts in the numerator and
some measure of a firm's assets in the denominator. The simplest measure of capital, a
leverage ratio, uses accounting equity (adjusted to remove intangible assets) and
accounting assets. For decades, however, the Basel Committee has preferred a risk-
based capital ratio, which uses a regulatory measure of capital and assets. Under this
framework, regulators allowed certain debt instruments, with minimal equity-like
characteristics, to be folded into the numerator, and for assets to be discounted by ever-
lower risk weights in the denominator. These adjustments encouraged increased
leverage among firms and were often amplified in certain jurisdictions.
An Opportunity Not To Be Lost"
Remarks by
FDIC Vice Chairman Thomas M. Hoenig
To the
22nd Annual Risk USA Conference,
New York, NY
November 9, 2016
Introduction
Basel III is scheduled to be finalized by year-end and presented to top regulators and
central bankers for approval in early 2017. The original goals of the six-year-long effort
were to "reduce the complexity of the regulatory framework and improve comparability"
and "address excessive variability in the capital requirements for credit risk."1 These
goals are laudable.
Unfortunately, as memory of the 2008 financial crisis has waned, the exercise has
added a third objective: ensuring that the final calibration of the Basel III framework not
significantly increase overall capital requirements.2 Should this occur, it would truly
represent an opportunity lost. Instead of strengthening the foundation of the global
financial system, as was intended with the original goals, Basel III would legitimize the
inadequate status quo and undermine the long-run objective of real financial stability.
In my remarks today I will discuss key factors that are at the core of the on-going debate
over what defines adequate capital. First, I will discuss the controversy over alternative
measurements for judging adequate capital. Simply stated, most measurements are too
complicated, set too low, and often vary by jurisdiction in ways that weaken global
financial stability. Second, relying only on public information, I will note changes that the
Basel Committee appears to be considering that will weaken current standards and why
these changes are ill-advised. Third, I will reiterate my concerns regarding Total Loss-
Absorbing Capacity (TLAC) and its use as a means to justify lower levels of capital and
require firms to issue more debt.
Capital Adequacy
Capital levels are reported as a ratio, with equity capital amounts in the numerator and
some measure of a firm's assets in the denominator. The simplest measure of capital, a
leverage ratio, uses accounting equity (adjusted to remove intangible assets) and
accounting assets. For decades, however, the Basel Committee has preferred a risk-
based capital ratio, which uses a regulatory measure of capital and assets. Under this
framework, regulators allowed certain debt instruments, with minimal equity-like
characteristics, to be folded into the numerator, and for assets to be discounted by ever-
lower risk weights in the denominator. These adjustments encouraged increased
leverage among firms and were often amplified in certain jurisdictions.
During the 2008 financial crisis, markets quickly turned away from measuring bank
stability with risk-based ratios and by necessity adopted the leverage ratio for its greater
reliability and comparability across banks and jurisdictions. Adjusting leverage ratios to
put firms on the same accounting standard quickly showed that while banks' risk-based
capital ratios were often roughly equal, their leverage ratios often varied widely.
Today, the average leverage ratio for the world's largest banks is around 5.5 percent.3
This average conceals significant outliers in certain jurisdictions that have leverage
ratios at pre-crisis levels of less than 4 percent, while they report risk-based capital
ratios on par with the world’s strongest banks. Such inconsistency serves to undermine
market confidence and financial stability, and is what the Basel Committee originally
sought to fix.
One bank's recent and widely publicized experience serves to demonstrate the effects
of such inconsistent standards. Its tier 1 risk-based capital ratio measured 14 percent,
while its leverage ratio was 2.68 percent. It became evident that markets viewed the
leverage ratio as the more credible measure of the bank's capital position, as
counterparties fled at the first sign of trouble.4 For these reasons, the Basel Committee
should not promise that there will be no significant increase in industry capital levels,
and it would be a further mistake to enshrine such capital standards with a regulatory
stamp of approval.
The last financial crisis exposed significant weaknesses in the Basel capital framework.
Risk-based capital did a poor job controlling management's risk appetite. It
misrepresented to the public the level of risk in banks and the industry. It resulted in
large misallocations of capital, of which a significant amount was distributed, leaving
banks ill-prepared and inadequately capitalized to absorb losses. For regulators to
ignore these lessons and begin to recalibrate and weaken the Basel III framework
before it is even fully implemented is counterintuitive and counterproductive.
The proposed recalibration of Basel III is especially disconcerting given that since
2008–2009 the largest banks have grown significantly in size and importance, and
remain highly complicated and highly leveraged. These conditions underscore the
dangers to the broader economy of having too little capital to absorb future losses when
they inevitably arise. Looking back, for example, the amount of losses and the amount
of TARP assistance that U.S. banks took in 2008 equaled nearly 6 percent of assets.
This means that if a systemically important U.S. bank incurred similar losses today, its
tangible capital would be gone. In response, market confidence would be shaken, which
could trigger fears of destabilized firms despite the presence of the Basel III framework.
In Europe, where tangible capital ratios are even lower, this level of loss would be
catastrophic.
While progress has been made in strengthening the capital positions of some of the
largest banking organizations, the numbers show that "improvement" is not the same as
"adequate." Thus, it is disappointing that some are suggesting that now is not the time
to raise capital further. The issue has even taken on a political tone, as some assert that
stability with risk-based ratios and by necessity adopted the leverage ratio for its greater
reliability and comparability across banks and jurisdictions. Adjusting leverage ratios to
put firms on the same accounting standard quickly showed that while banks' risk-based
capital ratios were often roughly equal, their leverage ratios often varied widely.
Today, the average leverage ratio for the world's largest banks is around 5.5 percent.3
This average conceals significant outliers in certain jurisdictions that have leverage
ratios at pre-crisis levels of less than 4 percent, while they report risk-based capital
ratios on par with the world’s strongest banks. Such inconsistency serves to undermine
market confidence and financial stability, and is what the Basel Committee originally
sought to fix.
One bank's recent and widely publicized experience serves to demonstrate the effects
of such inconsistent standards. Its tier 1 risk-based capital ratio measured 14 percent,
while its leverage ratio was 2.68 percent. It became evident that markets viewed the
leverage ratio as the more credible measure of the bank's capital position, as
counterparties fled at the first sign of trouble.4 For these reasons, the Basel Committee
should not promise that there will be no significant increase in industry capital levels,
and it would be a further mistake to enshrine such capital standards with a regulatory
stamp of approval.
The last financial crisis exposed significant weaknesses in the Basel capital framework.
Risk-based capital did a poor job controlling management's risk appetite. It
misrepresented to the public the level of risk in banks and the industry. It resulted in
large misallocations of capital, of which a significant amount was distributed, leaving
banks ill-prepared and inadequately capitalized to absorb losses. For regulators to
ignore these lessons and begin to recalibrate and weaken the Basel III framework
before it is even fully implemented is counterintuitive and counterproductive.
The proposed recalibration of Basel III is especially disconcerting given that since
2008–2009 the largest banks have grown significantly in size and importance, and
remain highly complicated and highly leveraged. These conditions underscore the
dangers to the broader economy of having too little capital to absorb future losses when
they inevitably arise. Looking back, for example, the amount of losses and the amount
of TARP assistance that U.S. banks took in 2008 equaled nearly 6 percent of assets.
This means that if a systemically important U.S. bank incurred similar losses today, its
tangible capital would be gone. In response, market confidence would be shaken, which
could trigger fears of destabilized firms despite the presence of the Basel III framework.
In Europe, where tangible capital ratios are even lower, this level of loss would be
catastrophic.
While progress has been made in strengthening the capital positions of some of the
largest banking organizations, the numbers show that "improvement" is not the same as
"adequate." Thus, it is disappointing that some are suggesting that now is not the time
to raise capital further. The issue has even taken on a political tone, as some assert that