Yesterday, in anticipation of the G-20 meeting of finance ministers that begins today, the Treasury Department published “Principles for Reforming the U.S. and International Regulatory Capital Framework for Banking Firms.”

The principles are intended to inform future international discussion of new capital standards for banking and other organizations. This discussion has been ongoing for over twenty years at the Bank for International Settlements (“BIS”) in Basel, Switzerland. In 2006, the BIS members finalized the so-called Basel II capital rules. European banks have adopted much if not all of Basel II. U.S. banks have not generally adopted Basel II, since the time to do so largely overlapped with the banking crisis that began in August 2007.

Basel II has been broadly criticized as, at best, a regulatory action that will do little, if anything to restore capital adequacy to the banking industry and, at worst, as a contributor to the banking crisis. Accordingly, the international dialogue on capital standards will begin afresh, and Treasury has laid down the following eight principles as guideposts for this discussion, which are in italics. A few comments then follow.

  • Capital requirements should be designed to protect the stability of the financial system (as well as the solvency of individual banking firms).
  • Capital requirements for all banking firms should be higher, and capital requirements for Tier 1 FHCs should be higher than capital requirements for other banking firms. Basel II provided for a three-tier capital regime, but based on technological capacity and supposed risk management as well as on size. The popular view was the higher-tier banking firms would, as a practical matter, be subject to lower capital standards.
  • The regulatory capital framework should put greater emphasis on higher quality forms of capital. If implemented, this principle may present challenges for U.S. banks—or their financial advisers. Over the last decade, banks of all sizes in the U.S. have taken advantage of the expanded range of Tier 1 capital instruments. In any case, it is not clear that the more innovative instruments have contributed significantly to the financial crisis.
  • Risk-based capital requirements should be a function of the relative risk of a banking firm’s exposures, and risk-based capital ratios should better reflect a banking firm’s current financial condition.
  • The procyclicality of the regulatory capital and accounting regimes should be reduced and consideration should be given to introducing countercyclical elements into the regulatory capital regime. Implementing a countercyclical regime has long been a goal of the Basel discussions; whether the effort will succeed this time remains to be seen.
  • Banking firms should be subject to a simple, non-risk-based leverage constraint. A broadly accepted concept today, these was the subject of an intense debate in the U.S. three years ago, with only the FDIC urging this point, against the opposition of most other federal agencies.
  • Banking firms should be subject to a conservative, explicit liquidity standard.
  • Stricter capital requirements for the banking system should not result in the re-emergence of an under-regulated non-bank financial sector that poses a threat to financial stability. This principle would result increased regulation and possibly new capital standards for non-banking firms—an issue otherwise outside the bailiwick of Basel.
  • Separate from the capital rules, banks should be subject to a conservative, explicit liquidity standard that prevents them from mismatching assets and funding sources.

At this point, there is no timeframe under which these principles would be assessed by the Basel group.