Brown-Vitter Capital Standard Trumps Risk-Based System

The Brown-Vitter bill has already had an interesting consequence in the few short days since its introduction. Not only has it caused an about-face by the megabanks, who are suddenly embracing Titles I and II of the Dodd–Frank Act, it also seems to have made them strong proponents of risk-based capital.

James Chessen of the American Bankers Association is the latest analyst to reflect that perspective, arguing that the leverage ratio provides "little useful information on the safety and soundness of a bank" and that "a risk-based ratio does a much better job distinguishing banks that go on to fail from those that survive." Chessen builds on the arguments recently made by the law firm of Davis Polk & Wardwell in its highly opinionated commentary about the Brown-Vitter bill stating that "the leverage ratio is too blunt an instrument for prudential financial regulation because it is not capable of distinguishing between risky and non-risky assets."

But the problems with both these points of view is that, in their attempt to criticize the leverage ratio, they downplay all the problems with the current risk-based capital system, including how the big banks recently gamed that system simply by stocking up on the assets with low risk weights and, in some cases, moving higher risk-weighted assets off their balance sheet.  As Federal Deposit Insurance Corp. Vice Chairman Thomas Hoenig has warned, risk-based capital creates the "illusion" that large banks have adequate capital to absorb unexpected losses.  The latest economic meltdown, including the bailout of our largest banks and the problems that the European banks have had with their sovereign debt are stark reminders of the problems with risk-based capital ratios.  We should never forget the fact that at the beginning of 2007, the ten largest banking firms in the U.S. had total Basel capital to risk-weighted assets averaging 11%, and all were considered well capitalized. But using tangible equity capital and total assets, the average leverage ratio for these same banks prior to the crisis was only 2.8%.

The large bank proponents also ignore the fact that the Brown-Vitter equity capital standard would go further than the leverage ratio and would be superior to that ratio since it would capture off-balance-sheet items.  Furthermore, it would also include derivatives exposures without, in most cases, the benefit of netting.  No longer could a large bank hide the true amount of its exposures to short-term debt by using structured investment vehicles, or confuse investors and the public about the amount of its derivative exposures.  If the Brown-Vitter bill were enacted, large bank balance sheets would become more transparent and would more accurately reflect the relative financial strength of the institution.  To give an example, Morgan Stanley's risk-based Tier 1 capital ratio at the end of the fourth quarter of 2012 was 17.72%, compared to its leverage ratio of 5.79%. But this leverage ratio would drop by almost a half to 2.55%, if International Financial Reporting Standards were used and the ability to net their $52 trillion derivatives portfolio was reduced.

No one is suggesting that banking regulators completely reject risk-based capital ratios.  Indeed, risk-based capital ratios could serve as a backstop or check for any type of tangible equity leverage ratio.  The Brown-Vitter bill specifically authorizes regulators to use them with respect to banks with over $20 billion in assets.  However, the Brown-Vitter equity capital standard would not only provide incentives for the largest banks to downsize, it would also replace the confusing and misleading risk-based capital system with a straightforward way to determine the true health of a banking institution.

Christopher Cole is senior vice president and senior regulatory counsel for the Independent Community Bankers of America.