The next financial crisis will not come from the traditional banking sector. So goes conventional thinking among financial policy makers. The world’s biggest banks are now safer, according to the narrative, thanks to stricter capital requirements and frequent stress tests that have curbed the appetite for extreme risk and tightened up lax regulatory standards.
I wish I were completely reassured. But as an accountant, I know that the headline capital numbers result from a subjective calculation. Banking regulators typically spend too little time digging into how those figures are calculated. I also know that when the US financial system is healthy, as it is now, we should strive to do better at accounting for potential losses, because that might cushion the blow when the inevitable downturn arrives.
To be sure, the big banks have all passed the Federal Reserve’s stress tests with flying colors. And this reflects substantial increases in capital buffers: the 35 banks that underwent 2018’s stress test have added about $800 billion in the highest quality type of capital over the past decade, according to the Fed. The central bank has deemed that the banks would therefore be strong enough to continue lending if the economy were to plunge into another severe downturn.
But I am not the only observer who remains concerned. In a speech to Americans for Financial Reform in May, Georgetown’s Daniel Tarullo, who was a Fed governor from 2009 to 2017, questioned the robustness of the stress tests. Banks know what regulators are looking for, Tarullo observed, enabling them to “find clever ways to reshape their assets,” thereby reducing their capital levels without reducing their risk exposures. And he also cast doubt on a Fed proposal to create a “stress capital buffer” to stop banks from running down their capital cushions by using dividend payments. Such a buffer, Tarullo argued, could actually prompt banks to take on even more risk.
This raises the tricky question of how capital levels are calculated. At times, banking regulators could be accused of fixating on the level of capital requirements without adequately taking into account how loan losses are provisioned for in a bank’s financial statements.
At the simplest level, the amount of capital a bank has on its balance sheet is the value of its assets, net of the value of its liabilities. But the values of these assets and liabilities are driven by accounting valuations. This therefore raises the most fundamental question of accounting: How do you measure an asset? Some assets are marked to market, while others are not. All these decisions trickle down to make up the amount of capital that the bank has. That figure, in turn, affects how much lending the bank undertakes, meaning that it has microeconomic and macroeconomic consequences. So any real understanding of capital levels requires regulators to understand how assets and liabilities are being measured.