Fed Regulations Are Making Banks Riskier

It's a bad sign that the Federal Reserve primary bank risk measure shows no correlation to four of five indicators of risk.

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Thomas L. Hogan and Neil R. Meredith are assistant professors of economics at West Texas A&M University. Dr. Hogan specializes in money and banking. Dr. Meredith specializes in microeconomics, econometrics, and healthcare.

Americans are becoming increasingly aware of how risky financial products, such as mortgage-backed securities, played a major role in the recent financial crisis. Few Americans, however, are aware that federal banking regulations encouraged banks to hold more mortgage-backed securities. In fact, the Federal Reserve is now in the process of strengthening these regulations, which will create more bank risk and the potential for more bank bailouts, with average Americans ultimately bearing the costs.

The Fed's faulty rules are part of an initiative known as risk-based capital regulation. After the savings and loan crisis of the 1980s, the United Sates joined an international banking agreement known as the Basel Accords. The Fed previously evaluated risk based on the bank's capital ratio, a measure of leverage calculated as the value of the bank's equity divided by the value of its assets. This changed with the adoption of the Basel Accords in 1991.

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The Fed now measures bank risk using a measure called the risk-based capital ratio. The risk-based capital ratio is similar to the regular capital ratio, except that each category of bank assets is weighted by its perceived level of risk. Assets perceived as risky receive higher weights, so banks must maintain more capital to compensate for the higher risk.

There are two main problems with risk-based capital regulation. First, it presumes regulators can properly identify the riskiness of every bank asset. For instance, before the mid-2000s, mortgage-backed securities were thought to be relatively safe, so regulators assigned them a low risk weight in the risk-based capital system. This gave banks an incentive to hold more mortgage-backed securities. In retrospect, this was a misjudgment of a serious magnitude.

Second, the risk-based capital ratio creates systemic risk in the banking system by encouraging banks to hold a lot of the same types of assets. In the United States, many banks invested heavily in mortgage-backed securities. A similar problem occurred in Europe, where regulations gave banks the incentive to hold large quantities of Greek government bonds. Neither of these cases ended well.

[Read the U.S. News Debate: Does the J.P. Morgan Loss Prove the Need for Tougher Bank Regulations?]

Despite the failures of risk-based capital regulation, some economists argue that the risk-based capital ratio should still be used by the Fed because it is more effective than the capital ratio at identifying risky banks. Others claim that the capital and risk-based capital ratios should be used together.

To evaluate these claims, we performed a study of risk-based capital regulation using data on U.S. banks from 2001 to 2011. We compare each bank's capital and risk-based capital ratios to five indicators of risk. Our recent Mercatus Center working paper (co-authored with Harry Pan) reports three primary findings:

  1. The standard capital ratio is a better predictor of every indicator of bank risk than the risk-based capital ratio.
  2. The risk-based capital ratio alone is not a good predictor of bank risk. A bank's risk-based capital ratio is related to its probability of failure but not to any other risk indicator.
  3. Using the standard capital ratio and risk-based capital ratio together is no better than using the capital ratio alone.
  4. [Read the U.S. News Debate: Should the Government Help Homeowners With Underwater Mortgages?]

    It's a bad sign that the Fed's primary bank risk measure shows no correlation to four of our five indicators of risk, especially when the capital ratio is highly related to all five. Taken with the other problems created by risk-based capital regulation, it appears that using the risk-based capital ratio creates serious harm without providing any noticeable benefits.

    Ironically, the Fed is currently in the process of adopting further risk-based capital regulations based on the Basel III agreement. These new policies were scheduled to be adopted in January, 2013, but their implementation has been delayed in the wake of the financial crisis.

    We propose that the Fed reverse course by ending its use of the risk-based capital ratio and return to using the regular capital ratio. This change would improve the Fed's measurement of bank risk, give banks an incentive to hold fewer risky assets, and reduce the likelihood of another financial crisis by preventing risk in the banking system. Then maybe Americans could sleep a little easier.

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