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Inside the thought-process of global bank stabilizer, the Bank of International Settlements, many things change over the years. The consortium of central banks is charged with setting the standard that provides a measure of a financial institution’s core strength and tends to adopt new standards yearly. Mandates to maintain these traits are packed in the continually evolving Basel accords.
However, one thing remains the same — the definition of Tier 1 capital as the greatest measure of a bank’s health. Tier 1 is essentially a bank’s assets, free of liabilities, balanced with the assets that are still encumbered by future liabilities, also known as risk-weighted assets.
Basel is meant to give banks a blueprint to avoid failure, and current events show this measure of stability is largely ineffective and also fails to properly predict the scope of trouble at Europe’s largest financial institutes.
Banks in the United States are falling behind European counterparts in adopting the latest Basel manifesto.
But, this is no reason to hit the panic button. Recent events show us Tier 1 capital levels offer no comfort against the potential for a bank to become insolvent.
On July 15, Franco-Belgian bank Dexia said it held adequate Tier 1 capital to prevent going under. And it seemed so, as it passed European stress test and met Basel standards for Tier 1.
But the EU was wrong, and Dexia crumbled and went into conservatorship.
The largest failure on the part of the Basel accords, therefore, is the inability to adequately factor in exposure risks outside of liquidity requirements.
Swiss-bank UBS Group (UBS: 12.66 +0.72%) said its Tier 1 capital ratio at Sept. 30 is 18.4%, which led the bank to make the highly questionable claim that it is one of the world’s best capitalized banks.
This claim is made despite the third-quarter earnings report also showing $49 million in exposure to the near-defaulted Icelandic government and $132 million in exposure to the likely to default Greek government.
However, the UBS exposure to Italian sovereign debt, central bank and other semi-government firms is a whopping $3.6 billion.
Considering the Italian government narrowly avoided a collapse Tuesday, the Basel committee may wish to reconsider what is uses to determine a bank’s overall health; one outside of capital requirements.
Write to Jacob Gaffney.