“THE NEWS in financial affairs centers on two seemingly unrelated phenomena. First, markets went into a bit of a tailspin over speculation that the Federal Reserve was about to curtail its stimulative monetary policy; Fed officials had to issue reassuring statements to calm everyone down. Second, federal financial regulators proposed stiff new capital requirements that would probably force some of the nation’s top banks to shrink.
“Actually, though, these events are connected: Some day, once the U.S. economy has returned to self-sustaining growth, the Federal Reserve will have to unwind its massive balance sheet. Interest rates will go up. Markets will react. And financial institutions could come under stress. One way to protect the wider economy against that potential instability is to make sure big banks are abundantly capitalized.
“Indeed, even if the Fed’s “exit strategy” goes off without a hitch, a key lesson of the financial crisis is that “systemically important” financial institutions need larger, more transparent capital requirements — lest policymakers face a no-win choice between market meltdown and taxpayer bailout. Prior to the crash, institutions such as Lehman Brothers and Bear Stearns had liability-to-asset ratios of greater than 30 to 1. Banks generally were given wide latitude to value their own assets, a practice known as “risk-weighting.”
“The proposed rule announced Tuesday by the Fed, the Federal Deposit Insurance Corp. and the Office of the Comptroller of the Currency requires the eight largest U.S.-based bank holding companies to keep the ratio between liabilities and assets at 20 to 1; for their FDIC-insured commercial bank subsidiaries, the ratio would be closer to 17 to 1. The standard is tough and clear. Though the precise definition of capital remains to be established, it is going to favor plain old shareholder equity and curtail risk-weighting.”
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