Net Net: Promoting innovation and managing change
Net Net: Promoting innovation and managing change

Basel Committee Seeks 9% Tier 1 Capital


Despite the return of sovereign debt fears arising in Europe this morning, there's some good news from across the Atlantic.

Cosmo Condina | The Image Bank | Getty Images

The Basel committee's latest draft on capital requirements will require banks to hold 9% Tier 1 capital, a huge increase over the 4% regulators previously required, according to a report out of the German weekly Die Ziet.

This will no doubt be bad news, at least in the short-term, for the shares of banks globally. Tier 1 capital is expensive for banks and raising capital requirements by that much will require banks to withhold dividends and issue new shares, diluting existing shareholders.

But over the long haul, this should result in better capitalized banks and a sounder financial system. This, in turn, would likely decrease the risk discount equity buyers put on banking stocks, lowering the required rate of return and raising P/E ratios.

The Basel Committee, which is meeting in Switzerland today, will also include a counter-cyclical "conservation buffer" that could push the Tier 1 requirement as high as 9% during boom years.

Reuters reports on the Die Zeit:

Banks will be required hold common equity — which consists of pure equity plus retained earnings — of five percent "after deductions", Die Zeit said, adding the requirement will come into force in 2013.

As part of Core Tier 1 capital requirements, which are more stringent that Tier 1 requirements, the conservation buffer and anticyclical buffer will be 2.5 percent each, the paper said.

The introduction of a conservation buffer will be staggered between 2014 and 2018, the paper said.

Furthermore, capital requirements can rise to 16 percent, if Tier 2 requirements are included, the paper said. This figure includes a 6 percent Tier 1 capital buffer, 4 percent of Tier 2 capital, the 3 percent conservation buffer, and the 3 percent anticyclical buffer.

Banking regulators and central bank officials from across the world meet on Tuesday to finalize their Basel III package of tougher bank capital and liquidity rules.

In an ideal world, of course, we wouldn't have regulatory capital requirements at all. Banks would set their capital at levels they deem prudent while equity and bond investors would price bank's equity and debt according to their assessments of the appropriateness of the reserves. Banks would then adjust their own capital levels to increase or decrease their funding costs.

Unfortunately, the practice of bailing out financial institutions destroys this market process. Moral hazard means shareholders and especially bond-holders won't discipline banks properly. This lack of discipline means that banks lack the guidance of market processes for assessing their risk. So we're stuck with relying on regulations.

The deeper problem, of course, is how regulators can assess capital requirements without a functioning market process. The short answer is that they cannot. They try to learn by trial and error, increasing requirements after a calamity. But this is guesswork at best.

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