A Tough New World for Banks. Or Is It?

Bank leaders from around the globe shook hands in Basel, Switzerland, this past weekend, agreeing on banking standards designed to prevent the global financial system from losing its mind again.

The new rules, known as Basel III, go like this:

• Minimum Tier 1 common equity ratios rise from 2% to 4.5%. Standard Tier 1 equity minimums rise from 4% to 6%. Total capital ratios are set at 8%.
• On top of those minimums, there's a "conservation buffer" that pushes all capital requirements up by another 2.5 percentage points. If banks' capital falls below these conservation buffers but are still above the absolute minimums, regulators can halt dividend and bonus payouts. "Prudent earnings retention policies," is how they put it.
• There's also a "countercyclical capital buffer" that can be imposed "according to national circumstances" (read: when regulators feel like it) of up to another 2.5% of common equity during "periods of excess aggregate credit growth," also known as bubbles.

How will these new rules affect our biggest banks? Basically, not at all. Here's how the new requirements compare with where the Big Four already stood in the most recent quarter:

Source: BIS, company filings.

None of these banks will likely have to raise capital to comply with the new rules. That's the good news.

Of course, the relative strength of four banks -- all bailed out by the government -- doesn't mean much. On a more international level, here's what rating agency Fitch found:

[F]ive out of 46 of the world's largest developed market banks would have failed the 4.5% common equity capital test with an aggregate common equity capital shortfall of USD20bn equivalent. Including the Basel Committee's 2.5% conservation buffer, these figures rise to 17 banks and USD120bn respectively. Including a full 2.5% countercyclical buffer (which can be met out of common equity or other fully loss absorbing capital), these figures rise to 35 banks and USD420bn respectively.

I'd ignore findings related to the countercyclical buffer. We're not in an expansionary credit bubble, so they're irrelevant for the time being. All in all, these results look good. A few global banks will have to raise $20 billion of capital. That's a drop in the bucket.

What's important, though, is the new rules' effectiveness. Will they make the world a safer place? Will they prevent another 2008-2009-style banking meltdown?

I think the answers to those questions are yes and no, respectively. Yes, Basel III will make the world a safer place -- higher capital requirements limit banks' ability to do stupid things and cushions the blow when they do. As to whether it will prevent another disaster like we just experienced, I'm not so sure.

The crash of 2008-2009 was caused by many ills. But too little capital, believe it or not, wasn't high on the list. Here's an incredible statistic: Just before Lehman Brothers blew up, it had a Tier 1 capital ratio of 11.6% -- sufficiently strong, to say the least. What sent it over the edge was a simple liquidity run. Ditto for Bear Stearns, AIG (NYSE: AIG), and the threats that nearly claimed Goldman Sachs (NYSE: GS) and Morgan Stanley (NYSE: MS). None of these companies had enough capital given the risks they took, but it was liquidity, not capital, that sealed their fates. In cases where capital was an issue, it was primarily a reflection of asset prices being temporarily vaporized because of the liquidity crisis. This is partly why the financial system kept exploding after TARP injected hundreds of billions of dollars of capital -- new capital doesn't necessarily extinguish a liquidity crisis. That's an important distinction to make, and one that Basel III doesn't directly touch. (The committee does mention new liquidity standards, but won't even try to codify rules until 2015). The new rules are a significant step in the right direction, but they're no panacea, as some like to think.

Also, get this. The new Basel rules don't go into effect right away; they're phased in between 2013-2019. Almost nine years out. Sure, companies need time to adjust to new regulations, but granting them nearly a decade seems outrageous and almost unconscionable. Nine years is enough time to heal from our current mess, form a new credit bubble, and suffer its eruption. Twice, maybe. After the U.S. banking stress tests in mid-2009, banks short on capital had one month to form a plan and six months to carry it out. And that seemed generous.

So is this a tough new world for banks? I don't think you can call it that. The requirements aren't particularly onerous, and take far too long to implement.

It's a wonderful and necessary step in the right direction, as is any plan designed to lessen the odds of another meltdown. But like so many attempts to reregulate the system, this is but one step ahead down the long road to sanity that we've barely begun walking down.