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s memories of the 2007-09 financial crisis fade, we worry that complacency is setting in. Recent news is not good. In the name of reducing the regulatory burden on small and some medium-sized firms, the Congress and the President enacted legislation that eased the requirements on some of the largest firms. Under the current Administration, several Treasury reports travel the same road, proposing ways to ease regulatory scrutiny of large entities without changing the law (see here, here and here). And, recently, the Federal Reserve Board altered its stress test in ways that make it more likely that poorly managed firms will pass. It also voted not to raise capital requirements on systemically risky banks over the next 12 months.
A few weeks ago, one of us (Steve) had the privilege to speak at the 20th Risk Convention of the Global Association of Risk Professionals (GARP). Founded in 1996, GARP engages in the education and certification of risk professionals and has several hundred thousand members worldwide. (Disclosure: Brandeis International Business School and NYU Stern are GARP Academic Partners.) The organizers allowed us to solicit the views of the 100-plus attendees on two issues that are central to financial resilience: Are bank capital requirements high enough? And, do central counterparties (CCPs) have sufficient loss-absorbing buffers? They answered both questions with a resounding “NO.”
As regular readers of our blog know, we remain concerned about the resilience of the system in general and capital requirements in particular. To be sure, once we take account of the updated definition of capital, the Basel III requirements are roughly 10 times the level of Basel II. Furthermore, actual capital levels at the largest global banks—measured by an equal-weighted leverage ratio—are now double what they were a decade ago.
Yet, views vary widely on whether current requirements and capital levels are sufficient. At one extreme, narrow banking advocates continue to call for depository institutions to finance anything but riskless assets with 100% equity capital. Admati and Hellwig argue that banks should operate with equity capital closer to 25% of total exposure. The Minneapolis Plan to End Too Big to Fail and IMF researchers (see Dagher et al) conclude that 15% would be sufficient, while Cline suggests that a leverage ratio in the range of 8% strikes the right balance between growth and stability. All of these are significantly higher than current norms.
What about risk management professionals? How do they answer when asked: “Are capital requirements high enough?” The distribution of responses from the GARP Convention attendees is striking (see the chart below). Only one fourth of the respondents believe that the current Basel III requirement of 3% is sufficient. The median response is 15%, and the weighted average is 13%. That is, people who manage risk for a living—including those that work for financial institutions—believe that current levels of capital (about 6% of total exposure) are insufficient, and would prefer capital buffers roughly twice as large (and requirements that are four times higher than the Basel III minimum)!
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