Earlier last week Jamie Dimon, CEO of JPMorganChase, said that Basel-III, the new international bank capital rules, is anti-American. A mandatory increase in bank capital has made the job of all bank CEOs tougher but I am not sure if it is anti-American or anti-European for that matter.
?Bank capital? is an oft misunderstood term and can be used to mislead legislatures who are rarely former bankers. It is misconstrued because it is often thought of as a pile of money that banks must hold in reserve or set aside passively, which is not the case. Bank capital is about how is money sourced rather than how it is used by the bank for various activities including lending. This is different from reserve or liquidity requirements like CRR and SLR, which concern how funds are deployed. For instance, in India, where CRR and SLR are 6% and 24%, respectively, if a bank raises a deposit of R100, it has to park R6 with RBI as cash reserve requirement. Similarly, it has to invest in liquid instruments like Government of India Securities for R24 as statutory liquidity requirement. It has to thus set aside R30 and will be able to use only R70 for lending and other investment purposes.
However, bank capital is not about funds deployment but about funds sourcing. If the bank puts in R10 of its own money, no part of it has to be set aside for meeting CRR or SLR requirements. It might lend R80, R70 of which comes from depositors and R10 from the bank. Its capital adequacy is 12.5% (R10/R80). The R10 that the bank puts into the business is sourced in the form of equity of around R7 and R3 of long-term bonds issued by the bank. Jamie Dimon is concerned about the return on investment on the equity because his job as CEO is to make high returns for his shareholders. Under the Basel-II regime, the source of funds for banks has to be around R5 of equity and R3 from long-term bonds. Now, the equity might increase to about R10. If the bank had earnings of R1, the return of equity earlier would have been 20% (R1 on an investment of R5), which now would go down to 10% (R1/R10).
Bank CEOs like Mr Dimon are lamenting that their bank?s return on equity might decline under the new banking rules. Therefore, despite knowing that the crisis might get worse and more bank capital would be valuable, they lobby furiously against increased equity requirements. They conveniently ignore, or choose to ignore the fact that lower return on equity is happening simultaneously with decreased leverage. Increase in equity decreases leverage, which, in turn, decreases the risk for the bank. Return on equity is meaningless without accounting for the risk, which depends critically on leverage. In 2008, the fallout from the high leverage that banks had, devastated the American economy.
Assertions that increased equity requirements would restrict lending and growth, are based on flawed arguments that seek to deliberately mislead. Lending decisions will be improved with more equity funding?if banks have more skin in the game, they will be more judicious in lending. The subprime crisis owed in part to lax lending decisions. It is too much leverage and not too much equity that causes credit crunches. Stricter capital adequacy requirements would avoid costly potential bailouts using taxpayers? money. Increasing bank capital would be painful for banks in the short-run, but there would be significant gains to the broader economy from a healthier and more stable financial system. Economies can grow and prosper with safer, less complex banks that deliver better value overall to the economy.
Mr Dimon has proposed that instead of regulators requiring all banks to increase capital, surviving banks should pay to resolve a failing fellow bank. This has some merit, but good banks paying for bad banks has its own pitfalls?it can jeopardise the well-being of good banks and possibly the economy. Increased equity requirements entails some costs to all banks but not exorbitantly high cost as rescuing a failed bank. Moreover, having high capital requirements may avert any bank failure in the first place. Requiring that all banks be better capitalised would serve the interests of the economy and also those of the good banks.
Arguments based on a level-playing field between American and European banks are fallacious. It cannot be an American national priority that its banking industry is successful internationally if it exposes the global economy to unnecessary risks and costs. To forestall the arrival of another costly financial crisis, US legislatures and regulators need to ask banks to have more skin in the game while banks expectedly lobby against such requirements. They should not allow flawed arguments and empty jingoism to affect policy making.
The author, formerly with JPMorgan Chase, is CEO, Quantum Phinance