The Fed's Re-examines "Too Big to Fail"

As the market waits for the Fed's statement summing up its rate-setting meeting, expected at 2 p.m. EDT, U.S. stocks are roughly unchanged this morning, with the S&P 500 (SNPINDEX: ^GSPC  ) and the narrower, price-weighted Dow Jones Industrial Average (DJINDICES: ^DJI  ) up slightly at 10:10 a.m. EDT.

Risk-weighted or risk-prone?
Is the Fed finally getting tough on too-big-to-fail banks? As political pressure to address the issue of banks that pose a systemic risk to financial markets and the economy mounts -- "TBTF" has not been properly addressed by Dodd-Frank -- the central bank is now considering raising the floor on the equity-capital-to-total-assets ratio above the 3% mandated under the new Basel 3 international standards.

At issue is whether so-called "risk-weighted" assets are an appropriate measure of the size and risk of a bank's balance sheet. Under this framework, different types of assets, from Treasury bonds to corporate loans, are assigned weightings, according to their risk. This ultimately lowers total asset figures, as the following table demonstrates:

Company

Total Risk-Weighted Assets, Basel 3 as of March 31, 2012

Total Assets as of March 31, 2012

Bank of America (NYSE: BAC  )	$1.388 trillion	$2.212 trillion
Citigroup (NYSE: C  )	$1.449 trillion*	$1.944 trillion

Source: Company documents *Base 2.5, estimated.

The concern of some politicians and analysts is that risk-weighted asset calculations depend on banks' internal risk models and assumptions that could allow banks to game the system by producing figures that understate the true risk of the bank. The 3% minimum ratio is based on total assets (unweighted), which cuts through this problem; unfortunately, the more prominent ratios cited under Basel 3 are based on risk-weighted numbers.

I've long written that the TBTF banks' capital requirements are insufficient. It's good to see that the Fed -- their main regulator -- is beginning to look at this problem more closely.

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