The shift to tougher capital requirements for banks is underway, but worries are already increasing that it won’t be enough to avoid the next financial crisis.

With the Basel Committee on Banking Supervision having spelled out many of the details of more stringent capital requirements toward the end of last year, national banking regulators are now turning their attention to implementing these new standards. In early February, Canada’s Office of the Superintendent of Financial Institutions took its first step in that direction, announcing its planned approach to introducing the new regime for Canadian banks.

Consultations on revised capital and liquidity rules are expected to begin later this year, but OSFI indicates that it doesn’t expect to begin working on the new leverage ratio that is to be introduced until the details of that measure are closer to being finalized. (The new ratio is to take effect by 2018, but is subject to an “observation period” until 2015, which is when it is likely to become more definitive.)

A recent research note from Toronto-based Stonecap Secur-ities Inc. suggests that although OSFI’s advisories provide less clarity than expected on the timetable for the implementation of the new regime (known as Basel III), the banks are probably content not to be rushed to comply with all of the new requirements — particularly when it comes to the new leverage restrictions: “Given that the leverage ratio is expected by some to be the most problematic for domestic banks to deal with… OSFI’s willingness to bide its time is likely welcome news.”

As well, OSFI has told the banks to prepare to phase out their use of financial instruments that will no longer qualify as core capital under Basel III starting in 2013.

None of this is expected to trouble the banks too much. A report from Toronto-based credit-rating agency DBRS Ltd. indicates that the Canadian banks are “well positioned” to comply with Basel III and that DBRS doesn’t expect the banks to face any capital constraints due to the pending rule changes, given the banks’ existing capital positions and their presumed ability to generate capital over the next couple of years.

All of this regulatory indulgence may be great if you’re a banker who’s focused on chinning up to the Basel III bar, but some are worried that the authorities aren’t doing nearly enough to prevent another crippling financial crisis. In addition, there are fears that the seeds of the next crisis are already being sown.

A paper from international consulting firm Oliver Wyman presented at the latest meeting of the World Economic Forum in Davos, Switzerland, imagines such a scenario. Although the paper does not predict an imminent crisis, it imagines how one could develop in the current economic climate. According to the vision the paper sketches, banks in the developed world, which are still being funded by cheap money, could begin to seek out higher-risk, higher-return activities when faced with slow growth in their home markets, leading them to the emerging markets and flooding those countries with capital and sparking a bubble in commodities prices.

Once markets realize that there is a bubble, that assets are overvalued and that much of this activity is unsustainable, these asset markets would tumble. And, as happened with the recent crisis that began with the U.S. subprime mortgage market, the effects would rebound on both financial services firms and government balance sheets, probably sparking another global recession.

The Oliver Wyman paper stresses that this is not a forecast of what is expected to happen; rather, the report represents an effort to stress-test the existing financial system by imagining the kinds of scenarios that could occur: “Our aim in describing it is to show that current efforts underway to create a better system should not be taken as an assurance that the system is now safe from future crises.”

In fact, although the scenario imagined in the Oliver Wyman paper might not materialize, it is not that far-fetched, either. The International Monetary Fund has made eerily similar observations in its latest report assessing global financial stability, which was released in late January.

That IMF report notes that the combination of expansionary policies in the developed world and favourable economic fundamentals in developing nations is luring capital to those emerging markets. And the report advises that “policy-makers in emerging-market countries will need to watch diligently for signs of asset price bubbles and excessive credit.”

Already, in some countries, private-sector debt is approaching recent historical highs — and the quality of that debt is deteriorating, the IMF report suggests.

Whether the current environment ultimately leads the world back toward crisis or not, there can be little question that financial crises will occur again. If not in emerging markets in the next couple of years, some other unforeseen trigger will be the source. And when the next crisis does materialize, banks may find that the reforms they have undertaken — particularly the increase in capital requirements — are not going to be enough to keep them out of trouble and prevent them from damaging the overall economy.@page_break@Indeed, some new research from the external members of the Bank of England’s monetary policy committee examines the amount of capital that banks should be holding to buffer them against negative shocks — and it concludes that the ideal number is much higher than the levels that banks will be required to reach under Basel III.

The BofE paper weighs the costs of capital requirements (higher borrowing costs and slower economic growth) against the benefits (reduced likelihood of a banking crisis and avoiding the real, permanent economic damage such crises can do). It concludes that the optimal capital level for banks is about 19% of risk-weighted assets (RWA).

The paper notes that Basel III “takes some significant steps” in this direction by raising the level of capital banks are required to hold (albeit to only 7% of RWA by 2019) and raising the quality of that capital (estimating that 7% of RWA under the new definition of regulatory capital is equivalent to about 10% under the old regime).

Nevertheless, the BofE paper says, the level should be higher still: “Our analysis suggests clearly that a far more ambitious reform would ultimately be desirable — a capital ratio which is at least twice as large as that agreed upon in Basel would take the banking sector much closer to an optimal position.”

Indeed, the paper argues it has been a “huge mistake” to let banks have much lower capital levels in recent years than they’ve held historically. The paper also says that it’s not clear that the costs of having banks use more equity is particularly large. In fact, the BofE estimates that doubling bank capital levels would increase the average cost of bank funding in the long run by only 10 to 40 basis points. And the paper suggests that it’s not clear that the economy has benefited from lower capital levels and higher bank leverage.

The problem, the BofE paper adds, is that regulators and governments have bought into the idea that equity is expensive. It maintains that policy-makers need to push banks to hold much higher capital levels.

The Oliver Wyman paper, for its part, calls on the regulators to acknowledge they can’t prevent crises but can push firms to be better prepared for them. That paper encourages regulators to make more use of the sort of stress testing that was used during the recent crisis (in the U.S. and Europe) as part of the ordinary supervisory process. Further, the paper calls on policy-makers to examine the sorts of government subsidies that distort financial markets. This includes everything from the implicit government backing for large, “too big to fail” banks to taxation and housing policy to the existence of government-backed lenders — all of which can impact prices, inflate asset bubbles and create large, systemic risks.

As for financial services institutions, they have to recognize that the glory days are over, the Oliver Wyman paper says: “The last couple of decades of constantly falling interest rates is over; customer demographics are shifting, regulations are tightening. Trying to replay the successful strategies of the past 25 years will not work.”

Indeed, bank executives need to recognize that with higher capital requirements, “the returns of the past are unsustainable,” it continues. And it’s essential that shareholders understand this rather than pushing banks to take irresponsible risks in search of higher returns.

Certainly, the conservative capital environment of the past couple of years does appear to be affecting bank returns. According to a recent UBS Securities Canada Inc. report, the looming rise in capital requirements has trimmed an estimated 570 bps from the average return on equity for the Canadian banks in fiscal 2010 vs 2008.

Still, the UBS report expects that ROEs will stay around their historical average of 16% this year: “While we project that higher capital will continue to be a headwind in [fiscal 2011 and 2012], we think high returns are structural, underpinned by an oligopolistic competitive structure, a sound regulatory backdrop and better economic underpinnings.”

Yet, it’s this power for maintaining returns in the face of efforts to toughen regulation that has some industry-watchers worried. “For all the rhetoric around a new financial order, and all the improvements made, many of the old risks remain,” warns the Oliver Wyman report. “The basic regulatory framework has been maintained with tweaked parameters.”

Thus, it may not take much to set the global financial system — and the economy — on course for another crisis fairly soon. IE