Treasury Outlines “Core Principles” of Capital

By Lisa Valentine

All capital isn’t created equal. That’s one of the lessons learned from the financial meltdown. A bank may say it has enough capital to meet regulatory requirements, but if that capital is based on risk underlying assets, then clearly the bank is not as stable as it appears.

The U.S. Treasury recently released its “Principles for Reforming the U.S. and International Regulatory Capital Framework for Banking Firms.” The Treasury has set a deadline of December 31, 2009 for issuing its domestic report on acceptable levels of capital requirement. The agency is looking to win international agreement on these capital requirement standards by December 31, 2010, with implementation set for December 31, 2012.

Treasury has outlined 8 “core principles” of capital requirements, which are summarized below:

1.    Don’t forget the forest for the trees: it’s not enough to establish capital requirements for individual banking firms but the requirements need to safeguard the banking system as a whole.
2.    Increase capital requirements for all banking firms, and make them higher still for Tier 1 financial companies. The Gramm-Leach-Bliley Act requires bank holding companies to keep its subsidiaries “well-capitalized” and “well-managed.” Treasury instead wants to expand the regulation to require a higher capital requirement for bank holding companies on a consolidated basis.
3.    Voting common equity should make up a larger portion of a banking firm’s capital. Deferred tax assets and non-equity hybrid and other “innovative” securities should be limited. Says the Treasury, “Voting common equity generally is a standardized and heavily traded capital instrument and, thus, provides the greatest source of market discipline for a [banking] firm.”
4.    Base risk-based capital requirements on the relative risk of the banking firm’s exposures and financial condition rather than relying on internal bank models or—worse yet—credit rating agencies.
5.    Require banks to hold a buffer over the minimum capital requirements that could be accessed when the economic cycle inevitably takes a downturn. Expect the worse, and be prepared. The good times don’t last forever (really?).
6.    Use a combination of freestanding risk-based capital requirement and freestanding leverage constraint when determining capital levels.
7.    Banking firms should be required to submit to a liquidity standard that is separate from the capital standard.
8.    Keep a very close watch on non-banks that try to get around the capital and liquidity requirements. Non-banks that pose a threat to financial system stability will be under the scrutiny of the Federal Reserve.

In an op-ed piece in the Financial Times, Treasury Secretary Tim Geithner had this to say about the Treasury’s proposed changes: “The fundamental principle is that capital and other regulatory requirements should be designed to ensure the stability of the system, not just the solvency of individual institutions. Such an approach requires a broad shift in the way capital and related regulations are designed.”

As we saw with the rapid-fire events in 2008, a lot can happen in just a few months. By the time these new capital requirements are legislated three years from now we could experience another financial crisis. If the Treasury really believes its statement that, “…capital requirements have long been and will remain a principal regulatory tool used by supervisors to promote the safety and stability of the banking system,” we would expect (and hope) that the regulators will speed up the process of moving higher capital requirements into law.

There’s nothing wrong with the core principles, per se. One of the only problems with the principles is that it could take years before they are legislated. By that time, the regulators and financial markets may consider 2008 a distant memory and an anomaly that won’t recur and will neglect to act at all.