“I could never say this in public, but all the fuss over executive compensation is a sideshow compared to strengthening capital requirements,” Barack Obama tells French President Nicolas Sarkozy.
In his New York Times column today, Joe Nocera imagines a pitch by Obama to his foreign peers about the need for better bank capital requirements. It’s a great column that at once illustrates the vast gap between the US view and the European view on financial reform, and argues strenuously for the US view.
As regular readers know, we’ve been arguing for months now against over-emphasising the role of compensation in creating the financial crisis. Regardless of whatever perverse incentives may have been created by the compensation structure on Wall Street, there’s just not much evidence that this actually led bankers to engage in too much risk.
What really seems to have happened was that banks believed they held relatively low risk mortgage backed securities that wound up being far riskier than expected. When the unexpected losses from these securities, we quickly discovered that banks were very thinly capitalised and held highly illiquid assets.
Any serious reform of the financial sector needs to focus on capital requirements. Everything else–from requirements for “plain vanilla” financial products, to consumer protection, to compensation reform–is just a dangerous distraction until this is accomplished. The biggest danger is that investors and regulators may mistakenly think they’ve fixed the problem when all they’ve done is spray anesthetic on a gangrene wound.
Nocera explains why the Europeans want to focus on compensation instead of capital requirements–their banks are more thinly capitalised and subject to far looser rules about what counts as good capital than US counter-parts. Better capital requirements will be painful for all banks. But far more painful for European banks that US banks.
So what needs to be done. Nocera spells out a number of steps:
- Banks need better quality capital. When the crisis got going, bankers argued with analysts about the quality of stuff called Tier 2 and Tier 3 capital. Those days quickly ended when investors figured out that all that really matters in a crisis is tangible common equity, the best kind of Tier 1 capital. Banks need to have capital from new equity or retained earnings, not imaginary capital created by accounting gimmicks.
- Capital requirements must be raised. Nocera says the current requirement for 4% Tier 1 capital may be raised to 8%. Even that number might be too low.
- Make capital requirements counter-cyclical. If the 8% is a minimum, banks must be required in good times to build up beyond that so that when hard times strike and balance sheet losses mount they have excess reserves to draw upon.
- The bigger the bank, the higher the capital requirements must be. We don’t have a credible way of getting out of the Too Big To Fail trap. What this means is that we have to force banks that grow too large to be so safe they can’t fail. This will likely mean higher capital requirements and restrictions on doing things like mucking about in derivatives.
- Stop relying on ratings agencies. There’s no way to fix ratings agencies. We need to get them out of our regulatory structure altogether.
The best part is the conclusion, where Nocera explains how Obama should try to force the Europeans to go along with capital requirement reform. Here’s the short version: we should remind them that the American taxpayer rescued the entire European financial structure by bailing out AIG.
We have spent somewhere around $150 billion saving one company, A.I.G. One the reasons we did so was to prevent many of your banks from collapsing. By having the American government back those A.I.G. credit-default swaps — the very ones your banks used to game Basel II — we upheld the illusion that those swaps represented genuine capital. If those swaps had disappeared during the crisis last year, many of your banks could well have failed.
I hope that in coming months, Tim and your finance ministers can come to an agreement on what a new capital regulatory regime should look like. But I’ve encouraged him to stick to the tough principles he articulated earlier this month, and that’s what he is going to do. Even if means that you wind up going your way, and we wind up going ours.
And if that happens? The next time there’s a crisis, you’re on your own.