The Unintended Consequences of Basel III: Reducing Performance Ratios and Limiting Bank Acess to Equity Funding Markets

What the paper says

Introduction Capital adequacy is desired by regulators and opposed by bankers. Since sufficient capital has the desirable characteristics of preventing excessive asset growth and technical insolvency, why would the banking industry lobby against most recent Basil III, which mandates even more capital than required under Basel I and Basel II? It has to do with competing for placement in institutional equities portfolios. Large banks have need for regular infusions of equity capital not only to meet regulatory minimums and to raise funds for growth but also as a means of keeping a prominent name in securities markets in order to maintain public trust and even make easier the quest for new business. The problem is that banks return little on their assets (perhaps 1%) as compared with non-banking industrial firms. So banks can compete only by using leverage. Bond markets tolerate such extreme financial leverage because of the high quality of bank assets, being mostly in loans receivable and high grade liquid securities. While debt markets tolerate far less leverage for capital-intensive industrial companies because of lower quality assets, manufacturers, which sell products rather than money, earn more return on assets and do not need to be levered. Among the metrics that matter to the stock market is the return on equity (ROE). So, lower return on investments (ROI) at banks is offset by higher debt leverage, resulting in ROE that competes with manufacturers. Since ROE directly affects equity price, bank stocks can now compete with industrial companies for portfolio space. (1) But the requirement for more common equity capital under Basel III reduces ROE. It is possible that ever-enhanced capital requirements (mandated by this and later Basel Agreements (2)) could at some point actually make bank ROE and stock price non-competitive with the rest of those in the market when trying to raise equity capital. A History of Bank Capital Bank capital has gone through dramatic reductions since the 1800s when banks--which then were financed almost entirely with deposits--were required to fund assets with 50% capital (Berger, Herring and Szego 1995). With the advent of the discount window at the Federal Reserve Bank (herein called the Fed) where banks could borrow in an emergency and with deposit insurance, the short term borrowing markets felt that the new collage constituting the new government safety net reduced the need for bank capital. With the safety net somewhat supplanting market discipline, capital dropped steadily to single digits where it is today. As Berger et al. point out, the safety net priced at subsidized premiums actually served to allow banks to have the highest allowable leverage of any industrial group. With the new risk-based capital requirements of Basel 1 in 1992, the amount of capital to assets rose since the denominator in the capital ratio became risky assets rather than total assets (Flannery and Rangan 2008). Also, the Federal Deposit Insurance Corporation Improvement Act (FDICIA) of 1991 requiring prompt correction action by regulators served to impose nontrivial penalties for deficient capital, giving an incentive for banks to voluntarily raise capital above regulatory minimums. As Stiroh (2004) found, the markets required more capital as banks were allowed to get into more aggressive lines of business. The FDICIA and the Omnibus Budget Reconciliation Act of 1993 gave depositors seniority over other short term liabilities, thereby removing the previous implied government coverage of all liabilities and causing the bank borrowing markets to require more capital. As Flannery and Rangan (2008) point out, by 1992 regulatory capital minimums for a time became largely irrelevant as the market itself demanded higher capital ratios. But, regulatory capital requirements remained in place. The Basel agreements allowed subordinated debt to constitute capital under Tier 2 requirements. …