Saving the banks: banks' weaknesses are a regulatory illusion.

Wriston, Walter B.


Saving the banks: banks' weaknesses are a regulatory illusion

Saving the banks: banks' weaknesses are a regulatory illusion


If Bobby Knight were to define an opposing basketball player as any person under five feet his opposition in the NCAA would disappear overnight. But even though the opposition had been "eliminated by definition," the reality of hard games to be played would remain.

Likewise, bank regulators, by the definitions they choose, are making American banks look a lot weaker than they really are. The common view is that the banking system in America is undercapitalized. This perception is largely based on ratios developed to measure capital adequacy. Since banking is a complex business, it is clearly useful to search for some simple indicator to measure the soundness of an institution. Such an indicator would be even more valuable if it could be used across borders. What no one seems to focus on is that in the search for such an indicator, the regulators have defined away billions of dollars of what they themselves used to believe was bank capital.

Unlike pollution standards, which are supposed to be based on scientific knowledge, new and constantly changing definitions of bank capital do not rest on such solid ground. Virtually every time the banking system has sold more and more securities to bolster capital, the regulators have changed and restricted the definition of what constitutes capital. Capital adequacy has become a race with no finish line.

While no one has ever come up with a universally accepted definition of what constitutes capital in the banking business, for years almost everyone, including the regulators, took the view that the purpose of capital was to provide a cushion against possible future losses. Few would quarrel with that definition of purpose. Since a bank's Loan Loss Reserve is explicitly designed to provide a cushion against possible losses, the regulators logically included it as part of capital.

When the economic climate looks threatening, Loan Loss Reserves are built by charging earnings in advance of possible losses. When an actual loss occurs, it is then charged to the reserve. Logically enough, in addition to Loan Loss Reserves, the regulators also included common stockholders equity, perpetual preferred stock, mandatory convertible notes, longterm debt and minority interest in equity accounts of consolidated subsidiaries in their definition of bank capital.

In January 1989 -- as part of their effort to arrive at a common international definition of capital ratios -- U.S. regulators decreed that a good part of the Loan Loss Reserves of commercial banks was no longer to be considered part of capital. They did not alter their concept that capital was a cushion against losses. They just extinguished a sizable portion of that part of capital that was explicitly designed to cushion those losses, even though the reserves were still there. When you change one part of a fraction, obviously the ratio changes and the cry then went up that the banks needed more capital. This remarkable reversal of a decades-old concept passed almost unnoticed by anyone but those immediately affected.

As the global slowdown that was then emerging was reflected in the banks' balance sheets, (since they are a mirror image of the economy in general) banks looked around for ways to raise new capital. The market for common equity was then anything but robust, so several kinds of new securities that would be attractive to investors and qualify as capital were invented in conjunction with investment bankers. Banks were not unique in this respect. Industrial companies were then also creating and selling new kinds of securities in order to inject fresh money into companies much in need of funds. These custom tailored equities pumped money into companies that needed it.

Banks were hindered in raising capital by another regulatory action. When an industrial company experiences financial difficulty, it often cuts its common dividend to a penny a share so that its securities may still be bought and held by hundreds of mutual and pension funds whose charters prohibit buying non-dividend paying stocks. When a bank gets into trouble, though, the regulators insist on the outright elimination of its dividend, thereby precluding a huge pool of funds from even considering investment in banks being asked to raise capital.

But when the banking sector began to follow industrial companies by selling various new kinds of preferred stock and mandatory convertible notes, the regulators once again began to define away all or part of this new capital. To make the matter more complicated, the definers came up with categories of capital called Tier 1 and Tier 2 that not only put new names on old instruments, but were accompanied by a host of new rules. Tier 1 was roughly analogous to what used to be known as "primary" capital. By redefining various forms of capital and forcing banks to move what used to be considered primary capital to Tier II, a new capital "shortage" was created by definition.

In addition to the Loan Loss Reserve, U.S. regulators retroactively moved mandatory convertible notes and auction rate preferred stock from primary capital to Tier II, wiping out several more billion dollars of primary "capital." Perpetual preferred stock, they ruled retroactively, was no longer to be considered Tier I capital unless it "qualified" and was noncumulative. (Only bank holding company issues may be cumulative). Once again huge amounts of capital disappeared from the regulatory radar scan by definition, and another door was closed to banks in search of capital. Once again the ratios had to be recomputed.

The other part of the capital ratio is of course assets. By defining what risk attached to what assets, the regulators assured themselves that the U.S. government would be able to sell its bonds to finance its huge debt, since they decreed that the purchase by banks of these securities required no additional capital. This action was not as blatant as the regulations issued in some foreign countries, which require that a defined percentage of assets has to be held in government paper, but it has much the same effect. Instead of making loans to private companies to finance the growth of the American economy (which loans require specified amounts of "capital" to support them) the banks were motivated to buy government bonds instead.

The question of capital adequacy in the banking system is an important one, but reliance on a simple ratio of capital to assets without examining what makes up the two factors in that fraction may lead to false conclusions. Instead of relying on the unexamined ratio, we should ask three questions: How do you define capital? How do you define assets? Have these definitions been changed? No one in this dangerous world would argue against prudence but by constantly changing the rules of the game in such a way as to extinguish by definition many billions of dollars of capital, less, not more, stability is put into the system.

Mr. Wriston was chairman of Citicorp from 1970 until 1984.