A GROWING DEBATE ABOUT SAFETY / THE WALL STREET JOURNAL ( RECOMMENDED READING )

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JULY 12, 2010.

A Growing Debate About Safety

By DAVID REILLY

Austerity versus stimulus is the great debate raging in Western economies. The next iteration, to be argued in the sleepy Swiss town of Basel and regulatory corridors in Washington, might be labeled safety versus growth.

With new financial-overhaul legislation near completion, banks' focus is shifting to the regulatory detail that will be vital for profitability. Most important: How much capital will they have to hold, and when will new rules kick in?

The Basel Committee for Banking Supervision, a group of central bankers and regulators, is at the center of the debate. It is expected to discuss at a meeting this week plans for the more-stringent global capital requirements it hopes to have in place by year-end.

In these discussions, banks look set to use weak economic growth and high unemployment as an argument against aggressive action. One likely claim is that tough new capital requirements, while increasing the safety of the financial system, would risk choking off credit creation and holding back the recovery.

Already the Institute of International Finance, a banking organization, has said capital changes could shave 0.6 percentage point a year from GDP growth and cut employment by 9.3 million in the U.S., Europe and Japan between 2011 and 2015.

Others will argue that going easy on banks, by delaying or watering down capital requirements with an view to fixing issues when the economy is healthier, may leave problems forever unresolved and create bigger crises in the future.

Governments spent or guarantee trillions of dollars to bail out undercapitalized financial institutions during the crisis, and central banks have had to keep interest rates abnormally low to help banks heal. Forcing banks to be more cautious might damp returns. It might also make bank profits more stable, with investors ultimately paying a higher multiple for that reliability.

But banks aren't just worried about how tough regulators are. Another focus is how quickly rules will be implemented. One reason U.S. banks have about $1 trillion in excess reserves on deposit with the Federal Reserve: They don't know how much capital will be enough, or what gauges will matter. U.S. regulators, for instance, have recently emphasized Tier 1 common equity, yet the broader Tier 1 gauge is still the official metric. Financial-overhaul legislation, meanwhile, imposes a leverage cap of 15 times equity but doesn't define what assets or capital are used in the calculation.

Certainty on such matters will give banks clear targets to manage to and relieve pressure on executives grappling with both regulatory and economic uncertainty. They would wince at, say, Tier 1 ratios of 10% or more. But they would find a way to deal with them. Not knowing is arguably the worst of all worlds.

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