Bank capital and human capital

The arrival of Hurricane Sandy on the Eastern shores of the US throws into stark relief the conversation in financial markets on how much regulation is the right amount. To some degree this is a conversation about bank capital versus human capital; how much risk are regulators comfortable with banks having and how much can people be trusted to do the right thing at the right time.

Financial history has shown us that while bank CEOs may sound the right notes, there are often individual actors on trading desks making decisions for their own self interest. The examples are numerous. These decisions may be driven by pay incentives, ego or fear of getting caught. Suffice to say, banks have made the case that they alone cannot be responsible for managing their own risk, in particular the systematic risk that big banks bring to the global economy.

Regulators on the other hand have not been overly impressive with their responses. Regulations have swung the pendulum from conservatism to de-regulation and back again. Following the financial crisis of 2008, the pendulum swung hard towards the regulatory side, and now already is coming back the other way by some actors on the regulatory stage. Much of this back-and-forth is a result of regulators being unable to decide which is better, trusting bank capital to pursue its own interests or trusting human capital to do the right thing. The situation has gotten worse as regulators of major financial markets have disagreed on important aspects of bank capital, leading to what we expect will be a phenomenal display of regulatory arbitrage. As Exhibit A we present the upcoming fragmentation of the world’s OTC derivatives markets, courtesy of the CFTC and the European Union. Exhibit B, a boost to European banks over their US competitors, is Dodd-Frank 165.

By now it should be clear that neither heavy regulation nor emphatic deregulation are the right approaches; a long-lasting solution is only somewhere in the middle. This means it is time for clear, simple limits on bank capital and leverage while putting faith in human capital to act within the appropriate parameters. Even before Hurricane Sandy, Basel III was hard stuff to swallow, let alone read (and as our posts can attest, we read that stuff). After Sandy, Basel III just doesn’t make sense.

Instead, we throw our support in favor of proposals from the Bank of England’s Andrew Haldane and Vasileios Madouros, the FDIC’s Tom Hoenig and US Senators Brown and Vitter for much simpler capital ratios. These ratios might be higher than some banks like and would potentially not deter more restructuring news such as UBS’s layoff of 10,000 employees, mostly in Fixed Income. However, they would eliminate much of the confusion surrounding Basel III, allow regulators globally to harmonize around one simple set of rules, and allow human capital to do the work that it does best: making sensible decisions around a set of clearly defined parameters.

For Basel III, it is time to say Enough Already. We have other things to do than quibble about CVAs and which assets are part of Level 2 and which don’t matter. Yes, banks need to hold more capital. But the current road that regulators are on is as messy as the destruction left behind by any hurricane.

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