It's probably too early to say whether the Basel III reforms, unveiled by the Basel Committee of the Bank for International Settlements on September 12, will achieve their goal of creating a more stable and sustainable global financial system.
The key take-out from the reform package - which following scaremongering from bank lobbyists, will not be phased in until 2013 and doesn't need to be fully implemented until 2018 - is that banks will have to carry "proper" capital, as opposed to non-capital "dressed up" as capital, equivalent to 7% of their risk-weighted assets. This is a massive increase from the pre-crash level of 2%.
This alone will surely boost their chances of surviving another financial meltdown without recourse to taxpayer funded bailouts and should also ensure that shareholders rather than taxpayers feel the brunt of the pain.
Predictably the banks have been claiming Basel III reforms on bank capital will jeopardize economic recovery (they seem to have forgotten we'll probably be back in boom territory by then) and push up the cost of credit.
While a minority of financial commentators including Felix Salmon are optimistic about the reforms, many others say Basel III is seriously flawed.
On The Economist’s Free Exchange website, Noah Millman welcomed the fact that banks will find it harder to obfuscate on what constitutes common equity ("core tier one equity"). Millman said: “Simplicity and transparency on how much equity banks actually have is welcome.”
However Millman also pointed to serious flaws in Basel III, including its failure to address the Basel II's principal contribution to the last financial crisis – the way in which risk-weights were calculated.
Basel II required banks to hold greater amounts of capital against their "riskier" assets. Meanwhile, they were permitted to hold very low-risk assets – or those that were deemed to be 'very low-risk' by ratings agencies, including toxic CDOs (!!) – with virtually zero capital. Millman said that, in view of its failure to change risk-weightings, Basel III:
“Effectively doubles down on Basel II. Banks will need to hold more common equity than ever - against their risk-weighted assets. That massively increases the incentive to find low-risk-weight assets with some return, since these assets can be more highly leveraged than risky assets.
Basically, Millman is arguing that Basel III - which is expected to be approved at a G20 summit in Korea in November - will have the perverse effect of encouraging rather than discouraging banker recklessness. If true, this is worrying stuff.
Pablo Triana, author of Lecturing Birds On Flying: Can Mathematical Theories Destroy The Financial Markets? takes a similar line. Writing in FTfm, Triana said Basel III could sow the seeds of further financial chaos:
The problem is that regulations allow the “risk” in risk-weighted assets to be made exceedingly small … The much-lauded capital “strengthening” announced by the Basel mandarins does little to assuage concerns. Total mandatory capital barely changes. The flawed metrics (credit ratings and VAR) that can easily disguise true exposures continue to rule supreme. The potential for another system-threatening blow-up remains intact.
This is gloomy stuff, and contradicts the near-universal positive headlines that greeted the arrival of the new capital regime in mid-September.
To conclude, I probably agree with the Bank of England’s Andrew Bailey that a lot will depend on how the new rules are interpreted, and particularly whether bankers are prepared to abide by their "spirit” as well as their "letter”. Speaking to the Lord Mayor's Banquet in the City of London, Bailey said:
Financial services is an industry where arbitraging rules and regulations is habitual, even addictive. Money is made this way. We have no desire unduly to suppress enterprise and innovation, but doing the right thing and preserving financial stability means accepting the spirit of the rules. This is not a small change.
Let me give you one important example. The new Basel agreement emphasizes loss-bearing capital – capital that can bear losses outside insolvency. It must stay that way, and not be chipped away under the banner of arbitrage masquerading as innovation.
I have been asked a number of times in the last week whether I think that the new Basel agreement sets capital requirements high enough. My answer is that if the capital buffers are in future genuinely loss bearing capital with no tricky wrinkles, and we keep to this outcome, we have taken a good step forward.
Bailey said that, in contrast to their behaviour before the crash, regulators must be ready and willing to "mount a robust challenge to stop dangerous business models and investment practices." That much is possible.
What worries me is not so much the flaws in Basel III itself. It is, as the financial commentator and author Yves Smith has pointed out in a recent Naked Capitalism blog post, all the areas it leaves out. She said without coordinated measures to address a range of other corners of the financial markets, including "off-balance-sheet entities, much tougher accounting, limits on rehypothecation and securitization reform", Basel III is incapable of setting the capital bar high enough.
Further reading on Basel II and Basel III:
- Revising Basel II—But at What Cost? by Vishal Vedi
- Tripping over Prudence—Ideas for a Sensible Fix for Basel II, by Samuel Sender and Noel Amenc
- Bankers square up to regulators over economic fall-out of Basel III by Ian Fraser
- Basel II Mark II, better for the bruising? by Anthony Harrington [blog post]
- Basel II—Its Development and Aims [checklist]
Tags: banking , Basel III , capital adequacy , central banks , regulation