Today’s GRR (Global Risk Regulator) really highlights the differences between two speeches, the first, given by Sheila Bair of the FDIC and the second, by the (now retiring) Susan Schimdt Bies of the Federal Reserve.

Both of the speeches, and particularly that of Bair, merely reinforce my view that the FDIC has got it drastically wrong and that the Fed actually understand what they are talking about. It is a real pity that it is Bies that is retiring.

Bair’s emphasis, time and again through the speech, is that the overall capital level within the system must not drop. The GRR people have picked up on this well. The other point I think they missed – as it was only a passing reference I am not surprised. Bair said:

…[w]e risk accelerating the contraction of our community banking sector…

This looks like a secondary concern, but the two taken together really inform us of her view. As I have said in the past, large banks, managing their risks well, will end up with lower calculated capital requirements under Basel II. Smaller banks will, generally, not be able to drop their requirements.

For the overall capital in the system not to drop then, at least one of the following must occur:

  1. The smaller banks will need more capital, placing them at a competitive disadvantage;
  2. Some of the bigger banks will need to hold more capital than they currently do; or
  3. Basel II must be implemented in a risk insensitive manner.

Option 1 seems to be out to meet Bair’s concern on the decline of the community banking sector. Option 2 is a problem as this means that, as a reward for doing all this work to manage their risks the big banks get slugged if they are less than the best – even if they are in better shape than they were. Option 3 is silly and just plain sucks.

Sorry, but I cannot see an option 4. Bair seems to be pointing either to option 2 or 3.

The problem comes down to Bair’s seeming obsession with the current capital level. As I discussed in the past, the 8% capital figure is not some carefully calculated number that has gone through extensive testing. It is no more (or less than) a guess – a number that seemed right at the time. If, overall, bank’s risk management processes improve there is no reason why capital needs to stay at the current level. Capital is a contingency – something there if things go wrong. If it is less likely that things will go wrong then it can be allowed to drop without increasing systemic risk above the current level.

Bair then proceeds to justify this by saying that banks are earning plenty of profits now, so why drop the capital? The answer, Ms. Bair, is simple – they are getting less risky if they are managing their risks better. Capital is a dead weight on banks. It is expensive funding.

Bies, on the other hand, understands the whole point of the exercise. This passage, in particular, shows this.

When developing minimum capital requirements, supervisors should continue to promote approaches that both minimize the negative consequences of risk taking by financial institutions and encourage improved risk-management practices, particularly at those institutions that could affect global financial stability.

This is the point. A mindless fixation with the current capital

level is not.