How New Global Banking Rules Could Deepen the U.S. Crisis

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THE 20% SOLUTION

In contrast to the near-term confusion, there is a simple notion for the long term that just might take care of most of Basel II's problems in one swoop. It could be put in place whenever this credit crunch finally ends. The concept is to require the banks to build extremely thick capital cushions that could protect against a multitude of sins and obviate the need for some of Basel II's micromanagement. With sufficient padding, banks wouldn't need to reduce lending during a recession because they would have plenty of capital on hand to keep them safe even if the riskiness of their portfolios increased. In an interview with BusinessWeek, Charles Calomiris, a finance professor at the Columbia University Graduate School of Business, put forward the idea of giving the banks a decade to sell more shares in stages and gradually raise their total capital to perhaps 20% or even 25% of risk-adjusted assets, up from the current Basel standard of 8%.

True, if banks had anything close to 20% capital cushions, their return on equity would be much lower, but so would their risk to shareholders. Calomiris notes that one of the key principles of modern finance is that leveraging up to juice profits, as banks do now, does nothing to improve risk-adjusted returns. Plus, requiring banks to hold much more capital would benefit society by lessening the need for taxpayer bailouts as well as reducing unemployment and other social ills that result from credit crunches. Says Calomiris: "I think the bankers have pulled an incredible game on everybody by making them think that an 8% capital ratio is sufficient."

Calomiris' idea is not likely to be popular with bankers. When told of the concept, Pamela Martin, the Risk Management Assn. regulatory affairs director, said: "That's nuts. It's not even funny."

Calomiris realizes, of course, that his idea opens a can of worms. For one thing, it wouldn't be fair to make commercial banks raise their capital ratios without demanding more capital from investment banks and hedge funds, which compete with them using far more leverage. Whatever the merits of his proposal, it's clear that Basel II won't be the last word on capital standards. Who knows? It just might be time for Basel III.

Coy is BusinessWeek's Economics editor.