The real problem is if you understand what a bank is, you wouldn’t be trying to use capital ratios to protect taxpayer money.

First, notice that the many of the same people clamoring for higher capital ratios have also supported ‘nationalization’ of banks, which means there is no private capital. So it should be obvious that something other than private capital is employed to protect taxpayer money.

Taxpayer money is protected on the asset side (loans and other investments held by banks) with lending regulations. That includes what type of investments are legal for banks, what kind of lending is legal, including collateral requirements and income requirements. That means if Congress thought the problem in 2008 was lax and misguided lending, to further protect taxpayer money they need to tighten things up on that side. And that would include tightening up on supervision and enforcement as well.

(Of course, they think the current problem is banks are being too cautious, but Congress talking out of both sides of its mouth has never seemed to get in the way before. Just look at the China policy- they want China to strengthen its currency which means they want the dollar to go down vs the yuan, but at the same time they are careful not to employ policy that might cause China to sell their dollars and drive the dollar down vs the yuan.)

So what is the point of bank capital requirements? It’s the pricing of risk.

With an entirely publicly owned bank, risk is priced by government officials which means it’s politicized, with government officials deciding the interest rates that are charged. With private capital in first loss position, risk is priced by employees who are agents for the shareholders, who want the highest possible risk adjusted returns on their investment. This introduces an entirely different set of incentives vs publicly owned institutions. And the choice between the two, and the two alternative outcomes, is a purely political choice.

With our current arrangement of banking being public/private partnerships, the ratio between the two is called the capital ratio. For example, with a 10% capital ratio banks have 10% private capital, and 90% tax payer money (via FDIC deposit insurance). And what changing the capital ratio does is alter the pricing of risk.

Banks lending profits from the spread between the cost of funds and the rates charged to borrowers. And with any given spread, the return on equity falls as capital ratios rise. And looked at from the other perspective, higher capital ratios mean banks have to charge more for loans to make the same return on equity.

Additionally, investors/market forces decide what risk adjusted return on investment is needed to invest in a bank. Higher capital requirements lower returns on investment, but risk goes down as well. But it’s not a ‘straight line’ relationship. It takes a bit of work to sort out all the variables before an informed decision can be made by policy makers when setting required capital ratios.

So where are we?

We have policy makers and everyone else sounding off on the issue who all grossly misunderstand the actual dynamics trying to use capital requirements to protect taxpayer money.

Good luck to us!

For more on this see Proposals for the Banking System, Treasury, Fed, and FDIC

Major Banks Likely to Get Reprieve on New Capital Rules

By Steve Liesman

June 10 (CNBC) — The world’s major banks may get a break from regulators and be forced to set aside only 2 percent-to-2.5 percent more capital rather than the 3 percent reported earlier, officials familiar with the discussions told CNBC.

News of the potential reprieve—which would affect major global banks such as JPMorgan , Citigroup , Bank of America , Wells Fargo , UBS and HSBC —helped stocks pare losses Friday afternoon.

The new rule, which would force the world’s biggest financial institutions to set aside more capital as a cushion against potential losses, is being imposed after the recent credit crisis nearly caused the collapse of the banking system.

The increased capital buffer would be in addition to a seven percent capital increase for all banks, which was negotiated at last year’s Basel III meeting.

The officials, who asked not to be named, made their comments after global banking regulators met this week in Frankfurt. The US has proposed a tougher three percent charge for big banks, but there has been pushback from some European nations, especially France. Negotiations are continuing.

The news comes after JPMorgan Chief Jamie Dimon rose in an Atlanta meeting this week and directly confronted Fed Chairman Ben Bernanke over the numerous new banking regulations, including a new surcharge for the biggest banks.

Officials say there is a more formal meeting in two weeks of regulators in Basel, Switzerland, where the actual percentage should be formalized as a proposal to global leaders.

Sources caution that the situation is still a moving target, with the U.S. apparently holding out for a higher global surcharge if other countries push lower forms of capital, other than common equity, to be used to meet capital requirements.

Earlier this week, U.S. Treasury Department Secretary Tim Geithner suggested that the higher the quality of capital, the lower the surcharge can be.