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When your capital ratio is between 8 and 10 percent, your bank is considered “adequately capitalized.” It does not enjoy all the privileges of a “well capitalized” bank, but regulators let it be.
If your capital ratio should fall below 8 percent, however, your bank is considered “undercapitalized,” and the regulatory grip tightens significantly. Your regulators are now required to “closely monitor the condition” of your bank; you are required to submit a detailed “capital restoration plan;” you may not increase your assets, e.g. make new loans, without permission from your regulators; you must obtain permission from your regulators to make any acquisitions, open a new branch, or engage in any new line of business; and your regulator may, at its discretion, require or forbid various further actions.
If your bank’s capital ratio should fall below 6 percent, it is considered “significantly undercapitalized.” Among various other provisions, your pay can be restricted; you can be fired; the board of directors can be replaced; your bank can be sold to or merged with another bank.
If your bank’s capital ratio falls below 2 percent, it is considered “critically undercapitalized” and your regulator must take control of your bank.
Clearly, the capital ratio matters.
But how is this ratio calculated? Some assets are risky, and others are safe. Shouldn’t banks hold more capital against risky assets than against safe assets? How much more?
The Basel rules—still in effect as of this writing—address these questions by distinguishing categories of assets according to their presumed riskiness and giving each category a risk weight. The capital ratio for regulatory purposes is computed as the bank’s capital divided by the bank’s total risk-weighted assets:
capital ratio = bank capital ÷ risk-weighted assets
As of January 1, 2002, these were the categories and weights:
Business loans, considered the most risky. Risk-weight: 100 percent.
Mortgages, considered only half as risky as business loans. Risk-weight: 50 percent.
State government bonds, considered not very risky. Risk-weight: 20 percent.
Bonds and other securities, including mortgage-backed securities (“Agency” MBSs) of government-sponsored enterprises such as Fannie Mae and Freddie Mac, considered not very risky. Risk-weight: 20 percent.
Asset-backed securities of private sector securitizers such as Bear Stearns or Lehman Brothers, including their mortgage-backed securities (“private-label” MBSs), that had received an AA or AAA rating from one of the three nationally recognized statistical rating organizations were considered, under the “Recourse Rule” adopted for the U.S. in 2001, to be no more risky than mortgage-backed securities of Fannie Mae and Freddie Mac. Risk-weight: 20 percent.
U.S. government bonds and cash, considered not risky at all. Risk-weight: zero—no capital has to be held against them.
For illustration of the effect of the different risk weights, suppose again that you are the manager of a bank. Suppose your bank has $8 million in capital and total assets of $100 million. But now look at how wildly your regulatory capital adequacy varies depending on the kind of asset your $100 million is invested in:
Suppose you hold all business loans. Because business loans are risk-weighted 100 percent, your bank’s risk-weighted capital is 100 percent of $100 million, which equals $100 million. Your bank’s capital ratio under the Basel rules is therefore 8 percent:
$8 million in capital ÷ $100 million in risk-adjusted assets = 8 percent
With this 8 percent capital ratio, your bank is considered just barely “adequately capitalized.” Your regulators are worried; you are anxious. If any of those loans should go bad, you’ll face all the hassles—regulatory scrutiny of every decision, the necessity to submit a “capital restoration plan” and the like—that face an “undercapitalized” bank.
Suppose you hold all mortgages. Because mortgages are risk-weighted only 50 percent, your bank’s risk-weighted capital is 50 percent of $100 million, or $50 million, so your capital ratio is 16 percent:
$8 million in capital ÷ $50 million in risk-adjusted assets = 16 percent
With this 16 percent capital ratio, your bank is considered better than “well-capitalized.” Your regulators are happy; you are tranquil.
Suppose you hold all mortgage-backed securities issued by Fannie Mae or Freddie Mac, or AA- or AAA-rated mortgage-backed securities issued by a private company such as Bear Stearns. Because such mortgage-backed securities are risk-weighted at only 20 percent, your risk-weighted capital would be 20 percent of $100 million, or $20 million, so your capital ratio is 40 percent:
$8 million in capital ÷ $20 million in risk-adjusted assets = 40 percent
With a 40 percent capital ratio, your bank is considered far better than “well-capitalized.” Your regulators are gratifyingly bored.
How the Basel Capital Adequacy Regulations Induced Banks to Load Up on Mortgage-Backed Securities
These numbers begin to suggest how the Basel rules led many banks to invest heavily in the mortgage-backed securities that turned out to be bad investments when the housing boom went bust.
Let’s do another thought experiment to understand how the Basel rules gave banks an incentive to switch out of other investments and into mortgage-backed securities. In this thought experiment, you, the reader, are again the president of an imaginary bank, call it Bank X. We assume that Bank X also has $8 million in capital. We further assume that:
business loans pay 7 percent interest,
mortgages pay 6 percent interest, and
mortgage-backed securities pay 5 percent interest.
Initially, Bank X has interest-earning assets of $100 million in business loans. On those you stand to earn income of $7 million annually if none default. Suppose you wanted to increase the income you could earn (potentially, at least, if the investments all pay off). How could you do so and still stay within the Basel rules? If you took full advantage of the different risk weights of the different kinds of investments, what’s the largest income you could (potentially) earn with only $8 million in capital?
Table 12.1 lays out the various options, which are also described in what follows. If you, the reader, would like to figure for yourself your largest potential income, pause here to do so before reading on.
* * * * *
Initially (holding $100 million in business loans), what is your capital ratio? As we saw above, because business loans carry a 100 percent risk weight, you have risk-weighted assets of the whole $100 million, so your regulatory capital ratio is your capital of $8 million divided by that $100 million in risk-weighted assets. That’s 8 percent, so your bank is just barely “adequately capitalized.” This original strategy is shown in Table 12.1 as Strategy A.1: Hold Business Loans (look ahead to see the table).
Suppose your stockholders (including yourself!) want a higher rate of return on their $8 million in capital, if you can earn it without too much risk. How might you increase your bank’s income? The first alternate strategy you consider might simply be to take in more deposits and make more business loans with those deposits. (That’s called “expanding your balance sheet.” See Appendix B.) Will that work? If you were to take in $50 million more in deposits and make $50 million more business loans with them, you would increase your potential income from $7 million to $10.5 million, but look at Strategy A.2: Increase Business Loans in Table 12.1 to see what would happen to your capital ratio if you were to do so. Those new loans would all carry a 100 percent risk weight, so your risk-weighted assets would increase to $150 million. Your capital of $8 million divided by that $150 million in risk-weighted assets would yield a capital ratio of only 5.33 percent. That’s “significantly undercapitalized,” so your regulators would relieve you of your duties and install new management if you were to take this approach. It won’t do.
What else might you do to increase the income your bank earns on its $8 million in capital? What if you make mortgage loans instead of busi
ness loans?
Following Strategy B.1: Replace Business Loans with Mortgage Loans, you could give up your business loans (sell them to another bank or let them mature without renewing them) and use the money to make mortgage loans instead. The Basel rules give you an incentive to do this because they treat mortgages as only half as risky as regular business loans. If you were to follow this strategy, your potential income would decrease to only $6 million per year, but look what happens to your capital ratio for regulatory purposes. Because mortgages carry only a 50 percent risk weight, your $100 million in mortgages amount to risk-weighted assets of only $50 million. Dividing your $8 million in capital by that $50 million in risk-weighted assets gives you a capital ratio of 16 percent, well into “well-capitalized” territory. That gives you some regulatory breathing space! How might you use that breathing space to increase your bank’s potential income?
Table 12.1 How the Basel Rules Led Banks to Buy Mortgage-Backed Securities
You could take Strategy B.1 to the next step, B.2, by “increasing leverage”—borrowing more—to expand your balance sheet with more mortgage loans: Take in another $100 million in new deposits and use the whole amount to make more mortgage loans, doubling the quantity you hold to $200 million worth. That doubles your potential income to $12 million, while you remain “adequately capitalized” for regulatory purposes, because your $200 million in mortgages amount to risk-weighted assets of only $100 million.
This process of changing the composition of a bank’s assets in order to escape the constraints of capital regulations is known as regulatory capital arbitrage. It allows a bank to accumulate more total assets with the same capital (“increasing leverage”—borrowing more—to pay for those assets) while staying within the regulatory rules.
The most significant and ultimately dangerous kind of regulatory capital arbitrage caused by the Basel rules, as amended by the Recourse Rule, involved buying mortgage-backed securities (MBSs). To increase their regulatory capital ratios, many banks did buy many MBSs, and many of the MBSs they bought were backed by subprime mortgages. Let’s continue the example to see why banks bought MBSs.
Consider Strategy C.1: Replace Mortgage Loans with Mortgage-backed Securities: You could sell your $200 million worth of mortgages (from Strategy B.2), to a private-label securitizer such as Bear Stearns or Bank of America, or to Fannie Mae or Freddie Mac. That securitizer could turn those mortgages into a mortgage-backed security that either receives an AAA rating from one of the big ratings agencies (Moody’s, Standard and Poor’s, or Fitch), or has the government’s (implied) guarantee if the securitizer is Fannie or Freddie. You could then use your $200 million to buy that MBS—which is based on the very mortgage loans you sold. (This is slightly oversimplified, because banks bought only the AAA-rated portions, called “tranches,” of the securities backed by the mortgages. This means they were not buying back rights to all the potential income from the mortgages, just most of it. The simplification does not affect the point being made here. See the end notes for an explanation of tranching, and how a MBS based on subprime mortgages can get a AAA rating.)
Strategy C.1 in Table 12.1 shows what would happen to your capital ratio if you made this switch from whole mortgages to MBSs. Because AAA-rated MBSs have a risk weight of only 20 percent, your $200 million in MBSs would amount to risk-weighted assets of only $40 million (20 percent of $200 million). Your capital ratio, accordingly, would jump from 8 percent to 20 percent, giving you still more regulatory breathing room. While your actions have decreased your total capital ratio from 8 percent ($8 million in capital ÷ $100 million in business loans) to 4 percent ($8 million in capital ÷ $200 million in MBSs), you have increased your regulatory capital ratio from 8 percent to 20 percent. That’s regulatory capital arbitrage.
The move to MBSs would reduce your (potential) income to $10 million, but that reduction can be temporary if you then use Strategy C.2: Increase Holdings of Mortgage-backed Securities. Your comfortably high regulatory capital ratio would allow you to increase your holdings of mortgage-backed securities again, by more than double if you are willing to take the risk of letting your total capital ratio fall to a new low. You can increase your holdings by another $300 million. Going to this extreme would increase your annual income (until and unless just a few of the mortgages go bad!) to $25 million, even while you remain “adequately capitalized” according to the regulators, as shown in Table 12.1, Strategy C.2.
The progression of Strategies A, B, and C (shown in Table 12.1) illustrates how regulatory capital arbitrage allows banks to increase their leverage and decrease their overall capital ratios even as they reduce their capital ratios for regulatory purposes. In the example, by taking advantage of the low risk weight assigned to MBSs as in Strategy C.2, you could accumulate millions of dollars’ worth of MBSs as you increase the leverage of Bank X from 11.25 to 1 ($92 million in deposits to $8 million in capital while holding $100 million in business loans) to 61.5 to 1($492 million in deposits to $8 million in capital while holding $500 million in MBSs) and yet maintain constant the bank’s capital ratio for regulatory purposes. Doing so would increase the bank’s potential income (remember, this is before expenses and assuming all those mortgages pay off!) from $7 million to $24 million per year.
The upside of regulatory capital arbitrage for less-prudent banks—those willing to increase their leverage to expand their balance sheets—is obvious. It gives them a chance for high returns on investment within the constraints of the Basel rules. Accordingly, during the boom, banks willing to let their actual capital ratios decrease sought out AAA-rated mortgage-backed securities to buy. Note that until quite late in the housing boom, almost everyone trusted the AAA rating to mean that these mortgage-backed securities were very safe.
The downside of this kind of regulatory capital arbitrage for banks is greater vulnerability to losses on their mortgage-backed securities if the housing market should get into bad trouble (a development almost no one considered likely until late in the boom). In our example, it would take losses on 8.0 percent of Bank X’s business loans to wipe out its capital at the outset, but after loading up on mortgage-backed securities, it would take losses on only 1.67 percent of those MBSs to wipe out its capital.
Again, this is a made-up example with simple numbers, and it is intentionally as extreme as I can make it in order to make the underlying arithmetic clear. But it illustrates how the Basel capital adequacy rules gave banks an incentive to borrow more deeply and to use the borrowings to load up on mortgage-backed securities.
The point of the example is not that all bankers expanded their balance sheets in a reckless grasping for more and more income, regardless of risk, as in Strategy C.2 of the example, just because the Basel rules made it possible for them to do so. Of course, some did expand their balance sheets imprudently; but not most. The point is rather that the Basel rules gave all bankers, cautious or incautious alike, an incentive to overinvest in MBSs, to buy more of them than they would have if not for the Basel rules.
The distinction is very important, because in fact commercial bankers (as distinguished from investment bankers) on average did not take on more leverage so as to expand their balance sheets during the housing boom, and most were demonstrably not disregarding risk. A strong case can be made, in fact, that, on average, commercial bankers stayed quite cautious.
Commercial banks in general maintained about the same moderate overall capital levels in the run up to the financial crisis. According to Jeffrey Friedman and Wladimir Krauss, “[i]n the aggregate, the regulatory (risk-weighted) capital level of U.S. commercial banks as of mid-2007 [near the peak of the boom] was 12.85 percent …, nearly 30 percent higher than the 10 percent level mandated for well-capitalized banks, and 60 percent higher than the 8 percent level mandated for ‘adequately capitalized’ banks.”
Even banks that did leverage up and expand their balance sheets to buy mortgage-backed securities were still being cautious in other ways: like almo
st everyone, the banks believed the AAA-rated securities were very safe, and they invested almost exclusively in these safest ones even though riskier, lower-rated (AA-rated) MBSs would have paid them a higher return (because they are slightly riskier) while receiving the same low, 20 percent risk weight as the AAA-rated ones. If bankers had been willing to take more risk for higher return, they would have bought AA-rated MBSs. They didn’t. They bought the safest, AAA-rated MBSs despite their lower return.
Even banks which maintained conservative overall capital ratios did, on average, engage in regulatory capital arbitrage, however. Like the more risk-tolerant banks, many of them also loaded up on mortgage-backed securities because the Basel rules and the Recourse Rule gave all banks an incentive to buy far more MBSs—both from Fannie and Freddie and from “private-label” issuers—than they otherwise would have. As pointed out above, U.S. banks overall invested three times as heavily in AAA-rated, privately-issued securities as did non-bank investors. (Recall that these “private label” securities lack the government guarantee given securities issued by Fannie and Freddie, so these are the ones everyone worried about when the housing boom turned to bust and mortgages started to default.)
Why would risk-averse banks engage in regulatory capital arbitrage and load up on mortgage-backed securities even if they did not intend to use the capital relief to leverage up? They did so to give themselves a bigger cushion above the 8 percent regulatory capital ratio below which their banks would be considered “undercapitalized.” For banks, this is their usable capital cushion as opposed to their regulatory capital cushion. The distinction is important. The eight percent (for “adequately capitalized”) regulatory capital floor is a cushion for the FDIC, which has to make good on insured deposits when a bank fails, and for taxpayers, who have to make up the difference when the FDIC’s Deposit Insurance Fund runs short. But that floor is not a cushion for a bank. A bank gets in expensive trouble with its regulators if it falls out of the “adequately capitalized” category. If it stays “undercapitalized” for ninety days, it can be seized by the FDIC and have its management replaced. For the banks, therefore, the regulatory floors are much more (hard marble) floors than cushions.