[OPE] Turning debits into credits, and liabilities into assets, Part 2

From: Jurriaan Bendien <adsl675281@telfort.nl>
Date: Thu May 07 2009 - 10:13:26 EDT

Although in this story by Mr Gapper corporate self-financing (and industrial
corporations acting as though they are banks) is ignored, the article
nevertheless makes some good points:

John Gapper, How banks learnt to play the system
FT May 6 2009

(...) Banks are highly leveraged institutions that hold only a small amount
of capital compared with their assets. That is what gives them their
economic importance - they can lend far more to people and companies than
their capital base - but also what makes them vulnerable. (....) [The] Basel
I [Accord of 1988] attempted to address this by setting a maximum leverage
ratio - or a minimum ratio of capital to assets - for global banks. That
figure was 8 per cent, which is equivalent to allowing a bank to be
leveraged a conservative 12.5 times. If that was how leveraged banks
actually were, we would not be in half this trouble. But some investment
banks entered this downturn with capital-to-asset ratios of 30 times or
more. That was because neither their assets nor their capital were what they

On assets, Basel introduced the notion of risk weighting, which essentially
meant that some kinds of loans - for example, highly rated corporate bonds
and, yes, residential mortgages - were considered less risky than others, so
less capital needed to be held against them. It was not a bad idea in
principle but it set off two decades of financial engineering by banks to
classify as many of their assets as possible as low-risk weighted in order
to swell their balance sheets and so make a higher return on capital.

One of the puzzles of the financial crisis is why banks were caught with
huge amounts of securitised mortgage debt when the point of securitisation -
turning assets into securities - is to be able to sell loans. Viewed through
the Basel lens, however, the hoarding of securities made sense. By
transforming 50 per cent risk-weighted mortgage loans into triple A
securities, and with the help of rating agencies, banks reduced the amount
of capital that they needed to hold against these assets. A bit of insurance
wizardry took the regulatory arbitrage further. Banks could cut their
capital charge to near zero by laying off the credit risk of mortgage
securities to AIG through credit default swaps. Hey presto, billions of
dollars of assets absorbing virtually no capital!

On capital, Basel was not as strict as it sounded. The 8 per cent figure was
split into two groups - tier 1 and tier 2 capital. Nobody talks much about
tier 2 capital now because it is pretty flimsy stuff - it includes
subordinated debt and other securities only distantly related to equity. For
years, regulators and investors have focused on tier 1 capital, which is
made up of equity, preferred shares, goodwill and intangibles. Banks must
hold a minimum of 4 per cent tier 1 capital to risk-weighted assets. Yet
even tier 1 is a loose measure of capital strength, since it includes
preferred shares and other miscellany. In practice, it is a bank's common
equity that absorbs the losses from its troubled loans and assets.

The result of this relentless deflation of assets and inflation of capital
is the absurdity that the banks which the US will today instruct to raise
billions more in equity are, by Basel standards, in rude health. Bank of
America, for example, had a tier 1 ratio of 10.1 per cent in the first
quarter of this year, while Citi's tier 1 ratio was 11.9 per cent. Both
banks had between two and three times the minimum ratio.
It would be wrong to throw away the entire Basel framework (including the
Basel II revision of 2004) because global banks found ways to game the
system. There is still a place for broad measures of banks' capital strength
and risk weighting of assets. But this Thursday's stress test results are
both a harsh judgment on the biggest US banks and a damning verdict on Basel
and two decades of capital adequacy regulation. We should remember that.

>From the NY Times:

"The banks are healing themselves, and it could have been done a lot faster
if government had gotten out of the way instead of parking the emergency
equipment in the middle of the road," said Gary B. Townsend, a former
banking regulator who now runs his own investment firm. It may come as a
surprise to many people that by most standards, all of the banks that
underwent these tests are already adequately capitalized. But regulators are
focusing on the amount of capital made up of common stock, the first layer
to absorb losses on bad loans. The government is betting that if banks have
a bigger buffer of equity, private investors will be confident enough in the
banks' health to pour money in. That should encourage the banks to start
lending again. "This is sending a message that the banks need more capital,
but their losses are manageable and the system itself is solvent," said
Kevin Fitzsimmons, an analyst at Sandler O'Neill. "Whether it sticks is
something else."

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