Wednesday, October 26, 2016

This Is No Way To Mend Europe’s Banks

By Editorial Board
The Bloomberg View
October 26, 2016

Europe urgently needs to repair a banking system that’s weighing on the region’s economy. Governments say they understand, but they still aren’t taking the task seriously.

The issue is global standards for capital -- the bedrock financing that makes banks capable of absorbing losses without going bust. Lack of capital in 2008 turned financial setbacks into a full-scale crisis. Regulators agreed on tougher capital standards back in 2010; now, the Basel Committee on Banking Supervision, which includes regulators from around the world, wants to firm up the rules that tell banks how to comply. Europe’s governments aren’t happy.

The hardest thing about regulating capital is measuring risk, because the riskier a bank’s investments, the more capital it needs. Banks disagree on how to judge the hazards: When presented with the same assets, they come up with different answers. And the temptation to underestimate risk, which would allow them to economize on capital, is always present.

Regulators therefore want to give banks less leeway in making this judgment. Ideas include bounds on the so-called risk weights that banks apply to their assets. Other proposals include a standardized method for calculating operational risk -- the likelihood of running into legal troubles such as those that recently sent Deutsche Bank shares plummeting. The aim is to put these changes in place by the end of the year.

This prospect has caused an uproar in Europe, home to some of the world’s largest and most thinly capitalized financial institutions. Executives argue the changes come at a time when banks are already struggling to turn a profit. Policy makers -- including German Finance Minister Wolfgang Schaeuble -- say the rules must not affect the region’s banks disproportionately. Some have suggested that the European Union should ignore them, undermining the Basel process for cooperating on financial regulation.

This reluctance is ill-advised. The new rules won’t affect banks that are already judging their risks cautiously, as regulators intended. And they’ll give banks that have weighed their risks more optimistically clearer guidance on what they need to do.

Regardless of how one measures risk, Europe’s banks still need more capital. Their failure to recognize losses and raise equity has left them with too many bad loans, and unable to invest in growth. Far from retreating on the new rules, officials in Basel should press for a higher minimum requirement for capital as a percentage of total (as opposed to risk-weighted) assets. This so-called leverage ratio is easier to calculate and tests resilience in unexpected situations where assets once deemed safe turn out to be risky. That makes it a useful backstop for the risk-weighted approach.

For years, Europe’s leaders have chosen to coddle an ailing banking system, rather than face up to its problems and fix them. This needs to change.

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