The Shadow Financial Regulatory Committee is a group of conservative-leaning, mostly academic economists and lawyers that meets quarterly at the American Enterprise Institute (AEI) to review and criticize actions of the federal financial regulators. At its Feb. 11 meeting, the Committee found much to criticize as it issued statements on Improving Bank Capital Adequacy Disclosure (#335), (improving) the Basel liquidity coverage ratio (#336) and Caveat Creditor: Qualified Mortgage (QM) Rule Fails to Protect Borrowers or the Economy.

In numerical order among the statements, Dick Herring, finance professor at Wharton and co-chair of the Committee, explained that the group has long advocated leverage ratios rather than risk-based measures as the preferable way of calculating the capital standing of banks. He cited three recent events as further evidence in favor of leverage ratios: 1) manipulation by the largest banks of their internal models to show less risk than they would have under an objective application of a leverage ratio; 2) a report by the Basel Committee showing widely divergent results when a portfolio of assets was evaluated by the respective risk models of major banks; and 3) the decision by the European Union, never enthusiastic about leverage ratios, to defer implementation of this standard for at least a year and maybe more.

Moreover, the European Union has recently experienced the collapse of a major bank that reported above-average risk-weighted capital ratios. In spite of all this, the Shadow Committee credits the Basel Committee with proposing a leverage ratio that is better than the method used by the United States today.

However, the Shadow Committee finds that as the Federal Reserve prepares to test the capital adequacy of the largest U.S. banks, it is using three measures based on risk weightings and a leverage ratio that is also deficient. This results in a significant understatement of the risks posed by “too big to fail” institutions such as Citigroup and Morgan Stanley.

The Shadow Committee further recommends that a method incorporating features of both international and U.S. accounting standards that takes into account the off-balance-sheet activities of banks be used by the Fed to conduct its review.

Finally, the Shadow Committee recommends that the required capital level be set higher than the 3 percent standard Basel adopted.

If the Fed were to follow these recommendations, the result would be a more reliable measure of capital that could be applied consistently across banks and across companies than is possible under the current, flawed method.

Next, Bob Eisenbeis, a former research director at two regulatory agencies who is now with Cumberland Advisors, discussed the methods used by the Basel Committee to compute liquidity ratios intended to measure the ability of the largest banks to withstand runs such as those that contributed to the 2008 episode of the financial crisis. The ratio is supposed to measure the ratio of high-quality assets to the total net cash outflows that could occur during a stressful period of 30 days. Eisenbeis explained that what started out as a simple exercise became highly complex, as the method was revised to include riskier assets in the numerator and a less meaningful scenario of liabilities that would run off during a period of stress.

The Shadow Committee contends that the authorities could do better by defining high-quality assets solely as cash and deposits at the central bank and by testing more stringent and realistic stress scenarios, then disclosing the results to the public.

Finally, Peter Wallison, senior fellow at AEI, continuing on the theme of complexity, explained the new QM rule promulgated by the Consumer Financial Protection Bureau under the Dodd-Frank Act. If a lender meets requirements designed to ensure that it has established the ability of the borrower to repay the load, the lender will be afforded a degree of protection against legal action by the borrower in the event that the lender wrongfully forecloses.

However, this entire system can be circumvented if the originator meets a much looser set of standards, such as a 580 FICO score, a 3 percent down payment and a debt-to-income ratio as high as 50 percent offered by government providers of mortgage credit such as Fannie Mae, Freddie Mac and the Federal Housing Authority.

Therefore, the Shadow Committee warns that unless major provisions of the QM rule are rewritten, the authorities will be setting the stage for another housing bubble that will trap millions more families in default and foreclosure and concentrate more risk in the largest too big to fail banks, all in the name of expanding opportunities for home ownership.

Taken as a whole, the Shadow Committee’s recommendations stand in marked contrast to the claims of administration officials and sell-side economists that the largest U.S. financial institutions are much stronger in terms of capital and liquidity than they were in 2008 and that consumers are now protected against predatory practices of avaricious mortgage originators.

The reason the financial crisis developed half a century ago and has grown and compounded in its ability to threaten the U.S. and global financial systems and economies, even as a series of measures has been enacted over the years, is that nothing has ever been done to contain this ongoing, seemingly permanent crisis.

Based on these latest pronouncements by the Shadow Committee, nothing has changed. If anything, the current circumstance is even more dangerous, because rather than curtail the moral hazard presented by the ability of the largest banks to incur ever-larger risks both on and off their balance sheets, the Treasury and the Fed will devise programs under which the government will buy the riskiest assets, provided that lenders have deployed them on a large enough scale to threaten the stability of the financial system.