Are NCUA’s Capital Requirements Outdated?
In 2015, NCUA reacted to risk-weighting imposed on banks under the BASEL III framework by creating a capital risk-weighting system for federally insured credit unions with $100 million or more in assets. Wouldn’t it be funny if by its effective date in 2019, regulators and policy makers decide that the whole risk-weighted approach to protecting against systemic risk makes no sense, or, at the very least, needs to be substantially reformed? This could happen. Over the last month:
- Jeb Hensarling (R), Chairman of the House Finance Committee, proposed giving banks mandate relief from certain Dodd-Frank requirements in return for maintaining a 10% leverage ratio in which a firm’s capital is measured against its assets without including risk-weightings in the calculation.
- Federal Reserve Chairwoman Yellen indicated that she also supported higher capital requirements in return for simpler regulation, but added that the option should be open to community banks.
- And, an influential European advisory board urged regulators last Friday to use a leverage ratio as a primary means of measuring a bank’s capital strength instead of risk-weighted assets.
To me, this growing realization that risk-weightings may not be the best way of gauging capital adequacy comes in the better late than never category. Between World War I and World War II, the French built a huge trench called the Magnot Line to protect themselves against future German attacks. But when World War II came, the Germans used tanks to maneuver around this trench and crush the French.
Risk weightings are the financial equivalent of the Magnot Line. For instance, weightings are, by definition, an assessment of an assets risk based on historical experience. The problem is that we don’t know what the equivalent of the mortgage backed security is going to be by the time the next financial crisis rolls around. Risk-weighting actually allows financial institutions to engage in regulatory arbitrage. Hopefully, the momentum will continue to grow and we can develop a system that places emphasis on capital and not guesses as to what banking products and investments are safe.
One more thing, in my dream world, an emphasis on capital leverage ratios would be coupled with a breaking up of the big banks. No amount of capital can adequately protect us against the need to bail out the Goldman Sachs or BoAs of the world. However, a more rigorous emphasis on capital requirements is a step in the right direction that would provide relatively small banks and credit unions greater flexibility and, I believe, just as much protection against severe downturns as does the existing risk-weighted framework.