Risk-based capital measures ‘too-often gamed,’ FDIC second chair says

Moving toward an assessment of bank capital adequacy based on tangible equity would generate better information and free up billions of supervision dollars used now to analyze risk-based measures “that are too-often gamed,” the vice chairman of the federal bank deposit insurer said Wednesday.

In a speech to the International Association of Deposit Insurers, meeting in Quebec City, FDIC’s Thomas M. Hoenig came down squarely on use of a tangible leverage ratio – computed by dividing tangible equity capital by total assets – rather than risk-based capital in determining the capital adequacy of a bank.

“From a supervision program perspective, moving away from risk-based capital measures toward an assessment of adequacy based on tangible equity would generate more reliable information from which to make supervisory judgments and would free up billions of dollars from supervision budgets currently spent computing and analyzing risk-based measures that are too-often gamed,” Hoenig told the group, members of which represent deposit insurance programs from around the globe.

The FDIC vice chairman noted that risk-based capital is better used by management to allocate capital on an internal basis, with that process being subject to examination, and can be useful for stress testing.

However, he said risk-based models as a forward measure of adequacy often “misinform” investors and the public.

“Unfortunately, capital adequacy today is judged by a number of highly complex and opaque risk-based measures,” he said. “One such measure, using internal models, shows tier 1 capital ratios of 14.38 as a percent of risk-weighted assets for U.S. G-SIBs (global list of systemically important banks).

“But then you learn that risk-weighted assets represent only 40% of total assets at these firms. No other industry is allowed to remove 60% of its assets from the balance sheet when its financial condition is assessed. This serves to mislead and give the perception of strength, especially when excessive risk is the order of the day,” he said.

He told the group that, historically (and especially in the recent financial crisis), the leverage ratio, not risk-based capital, has always been a more useful measure and predictor of solvency for regulators and the public.

He added that adequate capital as measured using a leverage ratio, in combination with strong bank examinations and supervision practices, is the best means to ensure sound banks, a safely funded insurance system, and a strong economy.

Hoenig said it is not a valid assertion that a more strict leverage ratio as the principal measure of capital adequacy might cause loan and economic growth to slow. He also rejected the claim that requiring higher capital standards would cause bankers to take on greater risks to boost returns.

“The Bank of International Settlements found that a 1 percentage point increase in the equity-to-total-assets ratio is associated with a 0.6 percentage point increase in annual loan growth” he said. “Other data show that the U.S. banks that entered the crisis in 2008 with higher capital levels had more modest declines in loans and recovered more quickly through the cycle. Concurrently, the banks going into 2008 with the lowest capital levels, including the largest banks, experienced the most dramatic declines in lending and highest rates of failure or bailout.

“The data are clear that strong capital allows for more flexibility in managing through the business cycle,” he said.

Deposit Insurance: Addressing Its Moral Hazard Effect” – Remarks by FDIC Vice Chairman Thomas M. Hoenig to the International Association of Deposit Insurers, 16th Annual General Meeting and Conference, Quebec City, Canada

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