Davis Polk quite faulty analysis of the Brown-Vitter Bill

Davis Polk when analyzing the Brown-Vitter Bill evidences that they, like most discussants of the issue, have not yet understood the very dangerous implications for the banking system which results from risk-weighing bank assets so as to determine their specific capital requirements for banks. With respect to this they write the following: 

“The Brown-Vitter leverage ratio is too blunt an instrument for prudential financial regulation because it is not capable of distinguishing between risky and non-risky assets, and could result in two banks with vastly different risk profiles holding exactly the same amount of capital. 

By making a leverage ratio the centerpiece of its capital framework, the Brown-Vitter bill represents a deliberate departure from the risk-based capital framework, notwithstanding the fact that the risk-based approach has been endorsed and adopted by all major economies around the world."

Let me explain a couple of real street life facts to these lawyers who have so clearly been captured by some desk illusions. If they then need more they can always go to my blog or call me. 

The perceived risks which are considered for setting the risk-weights are already cleared for by the banks on the assets side of the balance sheet, by means of interest rates (risk-premiums) amount of exposure and other terms. So therefore, forcing the banks to clear for the same perceived risks on the other side of the balance sheet, in their equity, only guarantees banks will overdose on perceived risks. 

When banks are able to hold less equity for “safe” asset than for the “risky” that translates directly into the expected risk adjusted return on bank equity on assets perceived as safe will be much higher than the same expected risk adjusted return on equity on assets perceived as “risky”, something which obviously introduces huge distortions and which make it impossible for the banks to perform their vital social function of allocating resources as efficiently as possible in the economy. 

The following question could also help to shed some light on this issue: “Do you approve that those who by being perceived as “The Infallible” are already much favored, should be additionally favored by the banks, and that those who by being perceived as “The Risky” are already discriminated against, should be additionally discriminated against by the banks?” Davis Polk, how do you think US Congressmen, in “the land of the brave” would respond to that? 

Davis Polk writes: 

“The inherent disadvantage of a leverage ratio such as the one in the Brown-Vitter bill is its inability to distinguish between risky and non-risky assets. Imagine two banks with exactly the same amount of tangible common equity and exactly the same amount of total assets. Bank A’s assets primarily consist of U.S. Treasury bonds backed by the full faith and credit of the U.S. government. Bank B’s assets primarily consist of the junior tranches of commercial real estate securitizations and equity exposures. 

The two banks would have exactly the same leverage ratio under the Brown-Vitter bill, notwithstanding their entirely different risk profiles. In contrast, under a risk-based capital framework, Bank B’s risk-based capital ratio would be lower than Bank A’s risk-based capital ratio, reflecting Bank B’s riskier balance sheet” 

And my question to Davis Polk would be: How do you know for sure Bank B is riskier than Bank A? What if Bank A held some long term U.S Treasury bonds and interest rates increased? Is not the US Government's strength a direct result of the audacity of its risk-taking citizens? 

Davis Polk also writes: 

“The Brown-Vitter rose-colored glasses view of U.S. banking history in the 19th century is contradicted by the facts” 

Well, Davis Polk, if you were to go to history then you would see that all major bank crisis have always been detonated by excessive exposures to what was ex-ante perceived as belonging to “The Infallible”, but turned out ex-post not to be, and never ever by excessive bank exposures to what ex-ante was perceived as part of “The Risky”. And just look at the current crisis… all bank assets that have created problems were those for which regulators allowed low capital requirements. And not a single of all bank exposure to “The Risky” has caused a capital insufficiency to appear. 

No, you in Davis Polk, instead of admiring so much what the Basel Committee has been up to, should really start to question their lack of wisdom. 

In November 1999, in an Op-Ed I wrote “The possible Big Bang that scares me the most is the one that could happen the day those genius bank regulators in Basel, playing Gods, manage to introduce a systemic error in the financial system, which will cause its collapse” 

And that is precisely what the Basel Committee did when it concocted the risk-weighted capital requirements, and no one questioned it sufficiently on it. Davis Polk, after the 2007-08 shock are you going to help the regulators to set us up for the next one? If we let them it seems it can only get worse, since now with Basel III they also want to add liquidity requirements based fundamentally on the same perceived risks. 

Davis Polk. I know you are lawyers… but do you really believe the US became what it is by having the banks avoiding risks? If the banks do not help society to take the risk it needs for the real economy to move forward, and to create the next generation of jobs our kids and grandchildren will need... who is going to do that? You and me? 

PS. Does this mean that I agree with the entire Brown-Vitter bill and with nothing of what Davis Polk states? Of course not! For instance I believe that capital requirements between 8 and 10 would suffice if we got rid of all of risk weighting? And I also think much thought should be given to how to help banks raise equity fast, so as to get over that problem and not allowing it to be a drag on the economy for years.

PS. Oh I forgot to mention the fact that minuscule capital requirements, resulting from minuscule risk-weights, are the best growth hormones ever for the too-big-to-fail banks.