If international efforts to craft new capital rules for banks don't go back to the drawing board for a significant overhaul, the United States should abandon the Basel III effort while it still can, says Thomas Hoenig, a director of the Federal Deposit Insurance Corporation.

“Given the questionable performance of past Basel capital standards and the complexities introduced in Basel III, the supervisory authorities need to rethink how capital standards are set,” Hoenig, former president of the Federal Reserve Bank of Kansas City, said during a speech Friday at the American Banker Regulatory Symposium in Washington, D.C. “Starting over is difficult when so much has been committed to the current proposal.  The FDIC is no different from other U.S. and international regulatory agencies where committed staff has devoted enormous effort to drafting and implementing Basel III. However, starting over offers the best opportunity to produce a better outcome”

Basel III will not improve outcomes for the largest banks “since its complexity reduces rather than enhances capital transparency,” he said. Nor will it help smaller institutions because “applying an international capital standard to a community bank is illogical.”

Compared to its predecessors, Basel III has a greater reach because it applies across all banking firms.

“Directors and managers will have a steep learning curve as they attempt to implement these expanded rules,” Hoenig said. “They will delegate the task of compliance to technical experts, and the most brazen and connected banks with the smartest experts will game the system.”

Basel III introduces a leverage ratio and raises the minimum risk-weighted capital ratios, but does so “using highly arcane formulas, suggesting more insight and accuracy than can possibly be achieved,” Hoenig complained.

“Where the markets assess, demand and adjust intrinsic risk weights on a daily basis, regulators using Basel look backwards and never catch up,” he said. “People knew well in advance of the recent financial crisis that the risk on home mortgages had increased during the period between 2005 and 2007, yet no changes were made to the risk weights. Basel III still looks backward as demonstrated by the few changes made regarding the weights assigned to sovereign debt.”

An alternative for assessing capital adequacy “must be simple, understandable, and enforceable” reflecting a firm's ability to absorb losses in both good times and times of crisis, Hoenig said, describing described his proposed alternative as a “tangible equity to tangible assets ratio.” Tangible equity, in his plan, is “simply equity without add-ons such as good will, minority interests, deferred taxes or other accounting entries that disappear in a crisis.” Tangible assets include all assets less the intangibles. 

“This tangible capital measure is a demanding minimum capital requirement within which management must allocate resources within the overall capital constraint,” he said. “[It] accepts that firms quickly shift their allocation of assets to take advantage of changing risks and rewards. This simpler, but fundamentally stronger, measure reflects in clear terms the losses that a bank can absorb before it fails and regardless of how risks shift.”

Assessing individual institutional risk and judging whether this minimum capital is adequate would be determined through the periodic examination process, something Hoenig said has become deemphasized in favor of stress tests” for big banks.