Global Rules Are the Wrong Fit for Small-Town Banks

International regulation for international banks has many virtues. Laws are largely territorial; finance increasingly is not. Global banks and investment houses create more value for their customers and the financial system when they work seamlessly across borders. 

Consistent regulations mean lower compliance burdens and fewer compliance errors, making financial institutions, their customers, and the global economy safer. The Basel Committee knows this, and it has worked over the years to make it a reality.

International regulation has fewer virtues, however, for local banks. Community institutions don't participate much in the global capital markets. They don't serve as diversified financial clearing houses, and few of their transactions leave the state, let alone the country. The rules that work well for global players are not built for small domestic banks — and if forced upon them, those rules can do more harm than good.

As proposed for the U.S. banking system, Basel III is one of those sets of rules.  It may work well for global financial institutions – though the jury is still out – but it should not be applied to smaller domestic financial institutions.

At its best, Basel III will raise the level and quality of capital in the banking system.  It brings Tier 1 capital closer to common equity and boosts required reserves for more volatile assets. But in an effort to make the rules risk-based and narrowly applicable to a plethora of different products and risks, Basel III has become unnecessarily complex and burdensome — which, in turn, makes it less effective.

For smaller domestic banks, Basel III's complexity, as troublesome as it can be, is the least of their worries. The proposal creates difficulties that are far worse.

Of course, every financial institution should have a strong capital base — and American community banks do, with an average Tier 1 common risk-based capital ratio of more than 18%. But the risks that these banks assume are different from those of their global counterparts, and community banks manage them differently.  Community and smaller regional banks do not have large traded positions or other investment banking and global trade-related complexities. They work in a reasonably defined geographic area, one where their knowledge of the businesses and demographics give them a different relationship to their borrowers. That doesn't just include banks under $500 million in assets anymore — there are $10, $20 or $50 billion regional banks that fit the same description.

When it comes to safety and soundness, the appropriate tools for this class of banking organization are simply different from those for global banks. Capital is important, but ample loan-loss reserves, governed by stringent supervision, are a much more direct, responsive way to account for credit risk. The complex, inflexible capital rules of Basel III are a red herring when it comes to smaller banks, seeming to make them safer when they may, in fact, do them harm.

The U.S. recognized these differences and took a simplified approach when Basel II was issued. We exempted small institutions from the standardized approach to calculating capital, and we left enforcement of capital sufficiency largely to the supervisors. 

We regarded capital as an important supervisory tool, but one of many. We set an immutable leverage ratio and other bright lines, but we let supervisors enforce higher standards where appropriate. (At minimum, this legacy is a good reason to grandfather existing capital instruments until they "run off." We shouldn't enforce sharp, immediate capital raises on community banks, especially when the low-interest-rate, low-loan-demand environment has dramatically cut the profitability of their core business lines.)

If regulators do decide to change the capital regime for community banks, then I hope they preserve the commonsense parts of our earlier system. New rules should be as simple as possible, setting bright-line minimums and giving supervisors the ability to increase them. They should reach for a universal leverage ratio and, for banks over $10 billion in assets, put the capital stress tests mandated by the Dodd Frank Act to good use.  They should recognize the difficulty a small firm has raising common equity on short notice, and base capital weights on real risks, not theoretical ones.

Basel is, at the end of the day, a profoundly important effort. But its rules aren't meant for American community banks, and we shouldn't hamstring such an important set of institutions with the wrong set of rules. 

We need simpler, tailored rules that will keep us from doing serious damage to this vital segment of our economy.

Eugene A. Ludwig is a founder and the chief executive of Promontory Financial Group LLC. He was the comptroller of the currency in the Clinton administration.