When there aren't many A's on an exam, good teachers don't simply make the test easier.
It seems a shame, then, that banking regulators look to be leaning toward that low road when it comes to new rules designed to force major financial institutions to hold more capital against bad bets.
In December, the international banking community's regulatory body, the Basel Committee on Banking Supervision, laid out a framework for new rules. In a nutshell, the riskiness of assets and what counted as capital would be under much tighter scrutiny.
The idea was to ensure that the banking business erred on the side of caution, whether it wanted to or not. It seemed sensible given that while subprime mortgages lit the fuse, a lack of capital in the banking system was the TNT that really blew up the financial industry. Once the losses began to mount, companies capsized far too quickly, forcing government bailouts.
However, all the signals since the Dec. 17 unveiling of the new capital rules are that they will be significantly watered down. That was the clear message from Canadian banks as they updated their shareholders in earnings season over the past two weeks.
As Rick Waugh, head of Bank of Nova Scotia, said on the company's conference call, the odds of the Basel proposal "actually seeing the light of day in its entirety is very slim." Mr. Waugh is generally viewed as a good weather vane on these matters, because he's plugged into the international banking world through committee work on rule making.
For bank shareholders in the near term, this trend to easier rules is a positive. Canadian banks will likely be able to resume dividend increases and earnings power won't be as impaired. American bank shareholders won't have to face as many dilutive stock sales from companies that have to reach the new thresholds for capital holdings.
Freed of capital constraints, Canadian banks may even resume their expansion in the United States, though that's probably more of a positive to U.S. banks selling at a premium than it is to Canadian buyers, given past returns on U.S. takeovers.
In the long term, however, this brings a nagging sense that banks globally are going to get off easy.
There's no getting around it; the regulations as laid out are tough. Even the vaunted Canadian banks didn't look nearly as good under the proposed new rules. Most analysts agreed that the key ratio of Tier 1 capital - the best bulletproof type of capital - to risk-weighted assets would decline by about four percentage points for the industry, to roughly 8 per cent.
No one would escape. Big investments such as Toronto-Dominion Bank's TD Ameritrade stake and Scotiabank's CI Financial investment wouldn't count for as much in capital tallies. Money in pension plans would also get more critical treatment. All of this is logical, given that the idea is to count only capital that is actually there to support losses if need be, and none of these assets are all that easy to sell on short notice to raise cash, especially in a widespread crisis.
Hardest hit would be Royal Bank of Canada, losing more than five percentage points from its Tier 1 ratio, according to analyst Sumit Malhotra of Macquarie Capital Markets Canada. One of the main reasons is RBC's big trading book, which would face a very stringent new risk measurement. Again, the logic is strong given that trading positions can go bad fast, and all at once.
For the same reason, the big U.S. banks with large trading operations will also face punitive calculations - including names such as Goldman Sachs Group Inc. and JPMorgan Chase & Co. No surprise, perhaps, given the lobbying weight of those players, that the new rules on trading risk are already being "talked down," in the words of one analyst.
Citigroup Inc.'s message to shareholders last week was not to expect any more big dilutions through share issues, which are the best way in the eyes of regulators to raise Tier 1 capital. Instead, Citi went ahead last week and sold $2-billion (U.S.) of securities that won't count as Tier 1.
Shareholders of Citi and other financial institutions are taking heart in the idea that Basel won't force more big capital boosts via share sales, judging by the hot performance of bank stocks in the U.S.
However, shareholders and bank managers need to ask themselves if they really want grade inflation in capital measurement that produces short-term gains at the expense of long-term stability.
Because for all the complex mathematical formulas that got the world in trouble, and that bankers are turning to under Basel to measure risk in the wake of that mess, there's a simple function that nobody should forget when it comes to testing banks:
Too much risk + Not enough capital = Disaster.