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The battle over bank capital requirements boiled over once again late last week when JPMorgan Chase

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[JPM  Loading...      ()   ] chief Jamie Dimon delivered an angry “tirade” against the idea of a “capital surcharge” for systemically important banks.

The new Basel III agreement—the rules regulators from around the globe agreed to late last year—calls for all banks to hold 7 percent capital, up from 3 percent. The biggest banks would be required to hold an additional 2.5 percent capital.

Dimon’s tirade was directed at Mark Carney, Bank of Canada governor, in a closed-door meeting in front of more than dozens of leading bankers and regulators, the Financial Times reports. According to the FT, things got so heated that Goldman Sachs

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[GS  Loading...      ()   ] CEO Lloyd Blankfein sent an apologetic email to Carney afterwards.

Dimon is obviously furious about the new capital surcharge. My sources tell me other top bankers are also dismayed — and grateful to Dimon for taking on the role of lead critic. It’s not something the heads of weaker banks — say, Citigroup

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[C  Loading...      ()   ] or Bank of America

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[BAC  Loading...      ()   ] — or more controversial banks — Goldman Sachs — are eager to undertake.

As I pointed out a few weeks ago, Dimon is right to criticize one aspect of the new capital requirements. Basel III involves complex risk weighting that is easily open to manipulation and regulatory arbitrage. Covered bonds, a structured finance arrangement popular in Europe, get a much lower risk weighting than other debt securities — which means banks that already own them (the Europeans) will have an advantage over those that don’t (the Americans).

Even worse, the regulatory view that covered bonds are much less risky is likely to spur a buying spree, and therefore a bubble in covered bonds. Instead of demand for covered bonds being driven for their perceived risk and return profiles, there will be regulation-driven demand. Banks will crowd into the trade to buy bonds on which global regulators have stamped their approval in the form of lower reserve requirements.

The main driver of this privileged status of covered bonds has been lobbying by European banks and European financial regulators who want to give their own banks a leg up in global competitiveness. It is, in effect, a back-door lowering of capital requirements for European banks. It’s just protectionism for European bankers.

If this pattern sounds familiar, that’s because it is. When the original Basel requirements were being negotiated, regulators from the Federal Reserve argued that mortgages should have a 100 percent risk weighting. Because the capital requirement for a well-capitalized bank under the original Basel agreement was 8 percent, this would have meant that for every dollar leant out for a mortgage, banks had to hold 8 cents of capital.

German financial regulators, however, lobbied hard against the 100 percent weighting for mortgages. Hoping to give a boost to their domestic housing market, they argued for a much lower rating.

Eventually, global regulators agreed to a 50 percent risk weighting, or 4 cents for every dollar leant out to a homebuyer.

As time went on, the advantages given to mortgages and mortgage-backed securities got even more extreme. The risk weighting for highly rated mortgage-backed securities dropped all the way down to 20 percent, triggering an appetite for bonds backed by home loans that eventually inflated the housing bubble and left the financial system badly over-exposed to mortgage risk.

Now we have Europeans arguing their covered bonds should get special treatment.

Dimon is also right about another thing: The higher the overall capital requirements are, the more incentive there is for banks to seek out the kind of loans regulators have decided to treat as special. The relative value of a covered bond with a 50 percent risk weighting is even higher as capital requirements go from 7 percent to 9.5 percent.

But Dimon is wrong to attack the surcharge in general. Indeed, he seems to have a deep misunderstanding of how it will affect his bank.

Later today, we’ll take a look at this more closely.

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