Why New Financial Reform May Not Work

The New Financial Reform as provided by the Basel Committee looks great on paper. It requires each bank to hold more capital. A Bank will now have to a hold a minimum of 4.5 % capital as compared to their assets or referred to as a common equity ratio. There will also be a conservation buffer of 2.5% which will allow the banks to pay raise the amount they pay for dividends if they exceed this buffer. Banks will also be required to have a tier 1 capital ratio of 6% which is based on risk weighted assets and a total capital ratio of 8%.

Lets provide an example of how the new financial reform does not do a lot. Bank of America in 2007 had a common equity ratio of 3%. Before raising capital from the government we can estimate Bank of America's common equity ratio dropped to 1.5% or so which is below the minimum requirements and forced the government to raise funds and they were able to finish the year with a ratio of 4%.

Bank of America could have operated with a lower equity ratio, but was forced to raise capital because of the requirements.

Now lets look at a future example.

In 2020 Bank of America has a capital ratio of 7% due to problems in the financial system their ratio drops to 3.8% which is much better than before but again below the requirements. This again could cause a government re-capitalization. Even though the bank is safer than before the government will be acting on the percentages.

Although Bank of America and other banks will be safer with these new rules, the rules are unlikely to prevent a future financial crisis, since the banks were forced to be lent money based on no longer meeting capital requirements. By raising the capital requirements and having to meet them creates the same future problem with better capitalized banks. If the government required banks to hold 100% equity ratio even if the banks were at 90% this would be a giant problem for the government, and the government would need to donate money to the banks to ensure there ratio hits the requirements. The only way to solve the problem would be to have flexible rules that raise the number for the common equity ratio, but in times of crisis allow the banks more flexibility and time to get back to their previous levels and this would allow banks to take advantage of holding a higher equity ratio which gives them the ability to make higher quality loans which may be the only part the banks will play in ensuring a better financial world. However, simply having more capital on the books means nothing if the requirements are raised.