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Higher Bank Capital Requirements are Necessary but not Sufficient

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The last ditch efforts to save Larry Summers' prospective nomination to run the Fed and the comments about his withdrawing from consideration have prompted further discussions of financial regulation.  The thrust of the comments is that Summers' big regulatory idea was that capital requirements are the key and other forms of rules are worthless because they are easy to evade.

Commercial bank capital requirements during the heights of the bubbles were absurdly low and the capital requirements for investment banks, Fannie and Freddie, sellers of CDS protection, monoline insurers, and mortgage banks were farcical.  The capital requirements for U.S. primary dealers and the largest commercial banks were reduced sharply during the expansion phase of the bubble.  The reduction in the capital requirements for Europe's largest commercial banks was far more severe than in the United States, so there is a "natural experiment" that can be used to research the effect of reducing capital requirements.

The Basel process was originally designed to prevent a regulatory race to the bottom by the "developed" economies through debasing bank capital requirements.  The Basel process was supposed to create a more uniform minimum bank capital requirement.  Basel II, however, embraced reducing capital requirements and ended up producing a much lower bank capital requirement in Europe than the U.S.

Basel II's evisceration of capital requirements proved disastrous.  One of the less understood aspects of the mortgage fraud crisis is how the FDIC's successful rearguard action saved us from the Fed's economists' efforts to push the full reduction in capital requirements of Basel II and delayed U.S. implementation of Basel II by two years.  Europe had no equivalent to the FDIC fighting the madness of Basel II's sharp reductions in bank capital requirements so it adopted the full reduction and it adopted that reduction two years before the U.S. implemented its considerably less radical reduction in capital requirements.

The perversion of the Basel process in Basel II into a device for leading, rather than preventing, a regulatory race to the bottom began in 1998 under the Clinton administration.  The perversion was led by the lobbying of the largest banks and the Fed.  Basel II was drafted in a manner that was a radical departure from Basel I.  The difference was that the industry was invited "inside the tent" by the regulators to participate actively in the rule making process.  This invitation went well beyond the input U.S. firms have in "notice and comment" rulemaking.  The largest banks were constantly involved -- for the better part of a decade -- making numerous ex parte presentations to individual government employees and committees.  The biggest bank strategy had several components that all favoring reduced capital requirements for the largest banks.    

The U.S. government's embrace of the regulatory race to the bottom and of a process dominated by the largest banks was consistent with the Clinton administration's embrace of both of those concepts.  President Clinton and Vice President Gore's "Reinventing Government" crusade had seven key precepts for financial regulation that I have explained in detail in prior articles.

  1. "Don't waste one second worrying about fraud"." (Bob Stone's explanation of the advice he gave Gore that led Gore to put him in charge of the "Reinvention" crusade)
  2. The industry members are the regulators' "customer" -- the public and Nation are not
  3. The U.S. must "win" the international competition in regulatory laxity (Summers' rationale for favoring the repeal of Glass-Steagall and the creation of the regulatory black hole for financial derivatives via the Commodities Futures Modernization Act of 2000)
  4. Financial regulators were direct to "partner" with the banks
  5. Financial regulators were directed to cease "imposing" rules and instead to "negotiate" them with their industry "partners"
  6. Clinton told the financial regulators at his first major meeting with them that he had received more criticism of their actions while he was campaigning than any other branch of government
  7. The Reinventers were particularly disdainful of enforcement actions and prosecutions against fraudulent firms and firms that polluted or otherwise endangered worker or public safety for this violated the central mission of treating the firms as customers and partners

Bob Rubin and Larry Summers were enthusiastic supporters of the Reinventing Government crusade.  I have not been able to find any record of them opposing the effort under the Clinton administration to use Basel II as a means to cause a dramatic reduction in capital requirements for the largest banks.

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After the Bush administration began, another Rubinite, Timothy Geithner, was made head of the NY Fed on October 15, 2003.  The NY Fed's economists played a key role in the Fed's support for the weakest possible Basel II capital requirements under Geithner and his predecessor.  The Fed's economists ignored and denigrated their supervisors' objections to the severe reduction in capital requirements.   Report of the Financial Crisis Inquiry Commission (FCIC) 2011: 171 (see also the Spillenkothen memorandum to FCIC).

The proposed Basel II reduction in capital made a mockery of U.S. law requiring the regulators to take "prompt corrective action" against banks with inadequate capital.

"[T]he results of the Fourth Quantitative Impact Survey (QIS4), conducted during the fall and winter of 2004-2005, exacerbated these concerns. This survey of 26 of the largest banks in the U.S. (including the banks that would be required to adopt the AIRB) showed substantial reductions in required capital on average. Indeed, if these banks had chosen to reduce their capital to these AIRB minimums, almost all of them would have had leverage ratios that would be categorized as undercapitalized and triggering prompt corrective action sanctions."

To put this all together, we have a real world test of administration economists' views and integrity.  The Basel II rule adopted by the U.S. was very poor, but because of the FDIC's courage and skill it was far less destructive than the version of Basel II that the Fed's economists championed and that Europe adopted.  The Fed/European version was indefensible.  It was contrary to the express will of Congress, all financial regulatory experience, and sound economic theory.  By looking at their contemporaneous positions on Basel II we can judge officials' actual views on capital requirements.  For example, Geithner is famous for claiming (now) that the key to regulation is "capital, capital, capital" -- by which he means higher capital requirements.

Geithner, however, was one of those who led the crusade to lower capital requirements for the largest banks. 

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Summers' supporters claim that he was "long" a supporter of higher capital requirements for banks.  Jeremy Bulow wrote that Summers was the best person in the world to replace Ben Bernanke as head of the Fed.  Bulow claimed that Summers was a great regulator.

"Because Summers has opposed some poorly designed rules, he is criticized as being against regulation. Actually, he's been in favor of regulating wisely. For example, he " has long supported requirements to boost bank capital."

"[H]e's in favor of regulating wisely" and he opposes bad rules -- how unique.  There's no content to this syrup.  The last sentence can be tested.  The Clinton Treasury could have killed Basel II's radical reduction in capital requirements for the largest banks.  Rubin and Summers (and Clinton and Gore) also could have stopped the biggest banks' constant ex parte ability to structure the rule to radically reduce their capital requirements.  We know that Treasury did not kill either the rule or the disgraceful manner in which the largest banks dominated the rule changes.  But perhaps Summers did actually write to oppose the rule and the ex parte procedural abuses and was overruled by Rubin or Clinton.  If he did, then he deserves considerable praise.  The question for Bulow is how long does "long" mean in his second sentence quoted above.  Does Bulow know that Summers believed in 1998 that the largest banks needed higher capital requirements?  If Summers did believe that in 1998 what did he do to try to stop the disaster that bore bitter fruit as Basel II.  Did Rubin and Summers implore Geithner to stop pushing to weaken bank capital requirements in the early-to-mid 2000s?

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William K Black , J.D., Ph.D. is Associate Professor of Law and Economics at the University of Missouri-Kansas City. Bill Black has testified before the Senate Agricultural Committee on the regulation of financial derivatives and House (more...)

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