The Flinchum File
Thoughtful Economic Analysis and Existential Opinions

Chinese Water Torture or Capital Torture

09/13/2010

Regulators for the world’s central banks meet in Basel, Switzerland. On two previous occasions, they have re-written the rules for banks worldwide. Now, we have the third revision, called Basel III.

The more capital a bank has, the less likely it is to fail and need taxpayer dollars. So, why not require banks to have lots of equity? Because it is an expensive source of funds! Banks make their profit on the difference between what they charge borrowers to borrow and what they pay for the funds they lend to borrowers. Checking accounts, for example, are a very cheap source of funds for banks to lend out. Investors who put capital into a bank demand much higher rates of return than checking account holders, reducing bank profits. Not surprisingly, regulators want a lot of capital and banks want very little.

Basel III does require more capital, but not as much as the banks and Wall Street feared. In addition, the new banking requirements are scheduled to phase in over the next seven years. Banks and Wall Street feared something much sooner. So, Basel III is not as tough as Wall Street feared, and bank stocks will likely rise nicely.

Basel III is another step in the right direction, just too slow. Like all generals who keep fighting the last war, regulators are still too focused on having capital to absorb inevitable loan losses, and not focused enough on non-banking activities done by banks using FDIC-guaranteed dollars, like proprietary trading in derivatives.

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