Despite every major US bank being declared by regulators as “well capitalized” prior to the financial crisis, we still found ourselves watching the government plow hundreds of billions of capital into said banks. How can this be? The answer is quite simple: we were lied to. Maybe that’s a little harsh, after all these banks did meet the regulatory definition of “well capitalized”. But when push came to shove, market participants rightly ignored regulatory capital. After all you cannot use things like “deferred tax losses” to pay your bills with.
It is hard to improve upon Martin Wolf’s observation in today’s Financial Times: “This amount of equity is far below levels markets would impose if investors did not continue to expect governments to bail out creditors in a crisis.” This point is best illustrated by the trend in bank capital over the last 100 years. Back when banks were actually subject to market forces and were not explicitly subjected to government capital standards, they held significantly more capital. In 1900 the average US bank capital ratio was close to 25%, now it’s closer to 5%. The trend is unmistakable: the more government has regulated bank capital, the less capital banks have ended up holding.
Despite the claims of the banking industry, what the bank regulators have just delivered with “Basel III” is simply another fraud upon the public and investors. Any framework that continues to treat say Greek or Fannie Mae debt as largely risk-free is a sham.
The real solution is to first end the various government bailouts, guarantees and subsidies behind the banking system, subjecting bank creditors to actual losses, while also abandoning the charade that is capital regulation. Sadly politicians (see the Dodd-Frank Act) and regulators continue to simply tweak a flawed and morally bankrupt system.