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Reassessing risk-based capital in the 1990s: Encouraging consolidation and productivity

  • John C. CoatesIV
Part of the The New York University Salomon Center Series on Financial Markets and Institutions book series (SALO, volume 3)

Abstract

This paper reassesses the risk-based capital rules, as they have been implemented in the 1990s, in light of ongoing consolidation in the banking industry. After briefly reviewing the theory behind the risk-based capital rules, the paper observes that although the risk-based capital rules have not been generally binding on US banks, they soon may become binding as a result of market forces that are pressuring banks to take steps that result in lower risk-based capital ratios. The paper then argues against past and likely future proposals to raise capital minimums on the ground that higher ratios would interfere with the healthy, ongoing consolidation in the banking industry. Next, the paper briefly reviews the status and treatment of three types of risk under the risk-based capital rules — concentration risk, innovation risk and acquisition risk — and argues that current rules perversely encourage the most risky type of bank growth (product innovation) while discouraging the least risky type of bank growth (acquisitions that produce greater geographic diversification). The paper concludes by calling for a re-evaluation of the way in which the risk-based capital rules apply to acquisitions, with a view toward better discriminating between risk-increasing and risk-decreasing transactions.

Keywords

Supra Note Large Bank Small Bank Capital Ratio Bank Merger 
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Notes

  1. 1.
    See Lovett, Moral Hazard, Bank Supervision and Risk-Based Capital Requirements, 49 Ohio St. L.J. 1365 (1989); Maceyand Garrett, Market Discipline by Depositors: A Summary of the Theoretical and Empirical Arguments, 5 Yale J. on Reg. 215 (1988).Google Scholar
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    See Sunstein, Problems with Rules, 83 Calif. L. Rev. 955, 1003 (1995) (contrasting costs and benefits of rules and standards).Google Scholar
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    Final Rule — Amendment to Regulations H and Y, 75 Fed. Res. Bull. 156 (Mar. 1989) (announcing adoption of risk-based capital rules).Google Scholar
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    See Bank for International Settlements Committee on Banking Regulation and Supervisory Practices, Report on International Convergence of Capital Measurements and Capital Standards, American Society of International Law (July 1988).Google Scholar
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  6. 6.
    The average Tier 1 ratio for the top 20 public bank holding companies, for example, was over6.60% in 1990, two years ahead of the full phase-in at 4°A; for all banks, the average was even higher, at 10.64%. Total capital ratios were similarly well above regulatory minimums well prior to 1992. See Appendix A. Claims that the risk-based capital rules caused or materially contributed to the last recession appear in retrospect to have been instances of special pleading, cf. Soft on Banks?, The Economist (Feb. 23, 1991), at 20, and in any event were simply wrong. Bergerand Udell, Did Risk-Based Capital Allocate Bank Credit and Cause a “Credit Crunch” in the United States?, 26 J. Money, Creditand Banking 585 (1994).Google Scholar
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    See Garten, Whatever Happened To Market Discipline of Banks?, 1991 Ann. Surv. Am. L. 749, 765. By contrast, the regulatory leverage ratio, which does not weight assets on the basis of credit risk, has been more of a constraint for some banks, although average leverage ratios have remained 150 basis points above the “well capitalized” 5% regulatory floor.Google Scholar
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    Bank for International Settlements, 66th Annual Report, at 84 (June 10, 1996).Google Scholar
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    See Herlihy, et al., Mergers and Acquisitions of Financial Institutions 1995, Securities Activities of Banks Fifteenth Annual Institute (Nov. 1995), at 118 (“Banks announced buybacks in 1994–95 of over $7 billion.”).Google Scholar
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    Id., at 33 (“There has been an increasing incidence of part-cash… transactions.”).Google Scholar
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    Berry, Levering Up: Declining Capital Ratios in the Banking Industry, 44 Keefe Bruyetteand Woods, Inc. Analyst Report (Sep. 13, 1996 ).Google Scholar
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    Shadow Financial Regulatory Committee, Statement No. 126 (Dec. 11, 1995 ); “Shadow Group Urges Rise in Risk-Based Capital Ratio,” The American Banker (Dec. 12, 1995 ).Google Scholar
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    Bank for International Settlements, supra note 8, at 86.Google Scholar
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  15. 15.
    Maceyand Miller, Bank Mergers and American Bank Competitiveness, Conference on Mergers of Financial Institutions (Oct. 11, 1996), at 3 (“bank mergers should… be viewed as a low-cost substitute for bank failures”).Google Scholar
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    Bovenziand Murton, Resolution Costs and Bank Failures, 1 FDIC Banking Rev. 1, 10 (1988) (1985 and 1986 data); Failed Banks, supra note 16, Tables 8 and 10, and accompanying text (presenting FDIC data on resolution costs of failed banks 1987–1992 and 1992–1993).Google Scholar
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    Bank for International Settlements, supra note 8, at 90–92, 167 (“The risk is that consolidation will proceed too slowly… [T]he reduction of excess capacity is essential.… Regulatory… obstacles to hostile takeovers in the banking industry… deserve more attention [from regulators].… [T]he reduction of artificial barriers to takeovers and mergers… would be helpful.”).Google Scholar
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    See note 12 supra.Google Scholar
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    See Modernizing the Financial System, supra note 16, at II-14; Rose, Higher Capital May Impair Bank Safety, Amer. Banker (1990), at 1, 4; Walland Peterson, The Effect of Capital Adequacy Guidelines on Large Bank Holding Companies, 11 J. Bankingand Fin. 581 (1987).Google Scholar
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    When the risk-based capital rules were first implemented, there was some concern that higher requirements would have the opposite effect — i.e., encourage consolidation (which was opposed by smaller banks). See Modernizing the Financial System, supra note 16, at II-16. However, at that time, the concern was more that the new rules would immediately put a large number of banks into capital noncompliance, thereby pushing them into failure or sale. Given that smaller banks generally hold capital well above any potential increased requirement, that result now seems unlikely.Google Scholar
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    Supra note 22. See also 58 Fed. Reg. 17,533 (1993) (describing likely negative impact of higher capital requirements on acquisitions).Google Scholar
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    See Garten, supra note 7; Jackson, The Expanding Obligations of Financial Holding Companies, 107 Harv. L. Rev. 509 (1994). Cf. Risk-Based Standards; Market Risk, Joint Final Rule (Aug. 29, 1996 ) (requiring banks with significant exposure to market risk associated with foreign exchange, commodity positions, and debt or equity trading positions, measure that risk 216 John C. Coates IV using its own internal value-at-risk model, and hold a commensurate amount of capital to support such activities ).Google Scholar
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    E.g., Risk-Based Capital; Concentrations of Credit and Nontraditional Activities, OCC-94–71 (Dec. 23, 1994 ). Regulators defended their decision on the ground that a formula-based capital calculation for such risks were infeasible because “there [was] no generally accepted approach to identifying and quantifying” such risks. While this may be true, it is also true that existing risk-based capital standards do not reflect any generally accepted approach for identifying and quantifying credit risk. A commercial real estate loan, for example, has the same risk-weighting as a credit card loan, even though losses on the two types of loans differ dramatically. Nevertheless, even rough risk-related adjustments to capital minimum are — if directionally accurate — arguably an improvement over uniform capital rules.Google Scholar
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    See Sunstein, supra note 2, at 964–65.Google Scholar
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    See, e.g., 12 C.F.R. § 3.10.Google Scholar
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    Fed. Reg. 44,866 (1992) (adopting prompt corrective action rules).Google Scholar
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    See 12 C.F.R. Part 327.Google Scholar
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    E.g., 12 C.F.R. Part 225, App. A and D (setting forth Federal Reserve policy).Google Scholar
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    See Fairlamb, Beyond Capital, Institutional Investor, (Aug. 1994) at 42 (“’That figure was seat-of-the-pants stuff,” admits Peter Cooke, the former Bank of England official who chaired the BIS Committee on Banking Supervision that hammered out the Basle Agreement.“) (cited in Conroy, supra note 25, at n.160)); Scott, Scholarship in Banking Law, 49 Ohio St. L.J. 1183, 1186 (1989).Google Scholar
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    Conroy, supra note 25, at 2418. Moreover, the studies on which the risk-based capital rules were based dated from the now-distant 1960s and 1970s, a period in which the banking landscape was entirely different. Id.Google Scholar
  35. 35.
    Average resolution costs have fallen dramatically since the enactment of FDICIA. See Proposed Rule: Assessments; New Assessment Rate Schedule for BIF Member Institutions, 60 Fed. Reg. 32 (Feb. 23, 1995) (losses per insured deposits averaged 16 basis points 1981–1993 and fell to less than one basis point in 1994). Studies of stock market reactions to FDICIA suggest that the prompt corrective action rules are expected to benefit shareholders, presumably by lowering resolution costs. Liang, Mohantyand Song, The Effect of the Federal Deposit Insurance Corporation Improvement Act of 1991 on Bank Stocks, 19 J. Fin. Res. 229 (1996).Google Scholar

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© Springer Science+Business Media Dordrecht 1998

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  • John C. CoatesIV

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