Swathes of assets just vanishing into thin air

Imagine if I told you I could reduce my own body weight by 80%, on paper, through a series of calculations utilising my own proprietary mathematical models, so complex and prized that I could not divulge them.

You would be right not to believe me, and might think I’m nuts. Yet this, in essence, is what regulators let banks do all the time with their balance sheets.

Huge swaths of assets are allowed to vanish, making too-big-to-fail financial firms seem leaner and safer than they are. Under the system known as risk weighting, banks get away with this because they are allowed to stipulate that some assets carry little, if any, risk.

Many government bonds, fall into the riskless category for purposes of determining regulatory-capital ratios. So a bank can assume it won’t incur losses on them, which allows it to keep a lower capital cushion. The flaw here is that rulemakers aren’t good at predicting what kinds of assets might blow up. Some governments, especially in Europe, are in awful shape and pose a real risk of defaulting. In other words, the notion of risk weighting is a farce, at least the way it is practiced now. Yet it carries the imprimatur of the Basel Committee on Banking Supervision, the Swiss body that writes capital standards for most of the developed world.

Thankfully, US regulator, Thomas Hoenig, has stepped up to say the standards should be scrapped. Former head of the Federal Reserve Bank of Kansas City, he now sits on the Federal Deposit Insurance Corporation’s board. And to see why he is right to do so, take a look at Germany’s Deutsche Bank. It had €2,240bn of assets on its Jun 30 balance sheet, which was prepared using the International Accounting Standards Board’s rules. Yet the company said it had only €372.6bn of risk- weighted assets. That’s the figure it used to come up with a 10.2% capital ratio for regulatory purposes.

So, somehow Deutsche Bank made 83% of its assets disappear. More than three- quarters of its assets consist of securities, loans and derivative instruments, all carrying varying degrees of risk. Yet the much smaller risk-weighted figure would have us believe that the bulk of tank’s assets were riskless. There’s no way to tell from the company’s latest report to investors how Deutsche Bank got this figure, except we know some asset classes, such as sovereign debt, are deemed much less risky by Basel rules than other kinds of assets.

The rules let the largest banks rely on their own proprietary models to determine how risky their assets are. The latest revisions proposed wouldn’t change that.

In a Sept 14 speech, Hoenig said the better way to assess capital adequacy is to develop a rule that is simple and enforceable: “It should be one that the public and shareholders can understand, that directors can monitor, that management cannot easily game, and that bank supervisors can enforce.” And it “should result in a bank having capital that approximates what the market would require” if no government safety net were in place.

The measure that best achieves those goals, he said, is a capital ratio that divides a bank’s tangible equity by tangible assets. Hoenig also would exclude deferred tax assets; profitable companies can use these to reduce their tax bills, but worthless to companies going broke.

Hoenig said a reasonable capital ratio would be 10% or higher. Deutsche Bank would look much weaker by this measure, mainly because the assets in the calculation would be about six times as large. Hoenig’s proposal has weak spots. Arguably, a 10% minimum isn’t high enough. And the contents of banks’ assets and liabilities wouldn’t be any more transparent than they are now. US banking regulators, are in the process of adopting their version of the proposals.