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Home > Capital Markets Viewpoints > Basel III: Uncharted Territory

Capital Markets Viewpoints

Basel III: Uncharted Territory

by Sir Howard Davies

Table of contents

Introduction

This article was first published in Quantum magazine.

If you believe the central bankers and regulators from the G20 countries who make up the Basel committee, now in conclave working out the final details of Basel III, it will be a prudent but well-judged package that judiciously balances conflicting objectives.

The committee accepts that its main stipulation—requiring banks to hold higher reserves—will have some economic impact. The cost of credit may be a little higher, so there will be somewhat less investment, and therefore a reduction in economic growth. But it expects that reduction to be less than half a percent over five years.

If, on the other hand, you believe the critics of Basel III, who include some powerful voices in the banks and financial institutions, you may regard a requirement to hold more reserves as a threat to global prosperity.

The Institute of International Finance (IIF), a trade body that represents the world’s largest banks and other financial institutions, argues that banks will struggle to raise the extra capital they need. As a result, credit offered by banks will be constrained, and the cost of loans to borrowers will rise.

The more reserves banks have to hold in the form of equity or unremunerated central bank deposits, the more they will have to charge their customers. That increased cost of credit could, in the IIF’s view, be sufficient to knock three full percentage points off global growth in the next five years.

Why are the differences between these two analyses so marked? It is partly because no such change has been imposed before, so there is no past experience to review. Capital in the banking system has gone up and down from time to time, but never before has there been an increase of this scale over a short period.

There are also some genuine uncertainties about the impact. Financial theory—the so-called Modigliani and Miller theorem—states that in the normal way a firm cannot alter the cost of its capital by changing the mix of equity and debt. So, if banks have more reserves and are therefore more resilient and less likely to fail, the cost of their debt should fall as an offset to the increased equity requirement.

Others dispute the validity of this theorem in the present circumstances. One difficulty is tax. Debt interest is deductible, while dividends on common equity are not. Altering that asymmetry might do more than anything else to strengthen the stability of the financial system.

Also, the impact on the cost of capital depends on the behavior of investors. Will they be prepared to accept lower returns from banks on the basis that those banks are safer? Again, theory suggests that, over time, expectations of the yields on bank stocks should change. But that may not happen quickly. So it will take years to discover whether the Basel committee or the IIF’s analysis is closer to the truth.

Whatever the outcome for economic growth, Basel III seems very likely to go ahead. The political mood is strongly in favor of strengthening bank reserves as politicians strive to avoid any future calls on taxpayers to rescue the financial system. The IIF has not been successful in preventing the large increase in capital requirements, though I suppose it could have been worse.

The Basel III Requirements

Capital Buffers

The main element of the new regime is that the minimum Tier 1 capital that banks have to hold will rise from 2% to 4.5%. But that is just the start of it. Then come the buffers. When I was a bank regulator there were no buffers, but now there are some fearsome new ones.

The first is the so-called conservation buffer of a minimum of 2.5%. This is to ensure that banks maintain extra capital which can be used to absorb losses during periods of financial and economic stress. If a bank’s ratio drops below 7%, regulators will constrain its freedom to pay bonuses and dividends. That will be a powerful incentive to stay above 7%.

Nor is 7% the final figure for all banks. For systemically important financial institutions there will be a new, countercyclical capital buffer, whose purpose is “to achieve the broader macroprudential goal of protecting the banking sector from periods of excess aggregate credit growth…” (Basel Committee on Banking Supervision, 2010). It is designed to cope with the procyclicality which many now see as one of the most dangerous flaws of the old regime.

There is, though, a lot of work still to do on this second buffer. How do we determine when credit growth is “excessive”? Who will make that judgment? What if different countries reach different judgments on similar facts? These matters are now being thrashed out behind closed doors in Basel.

Quality of Capital and Liquidity

Just as important are the steps taken to strengthen the quality of capital. One lesson painfully learnt in the crisis was that some of the hybrid instruments which had been counted as capital under Basel II did not provide a useful source of funds when asset prices fell. So, in future, regulators will be interested only in tangible common equity.

The third key element is a new liquidity regime. Liquidity regulation has been relatively neglected by the Basel committee in the past. Several attempts were made to devise international rules, but the issue has regularly been put into the “too difficult” tray. Now there is at least the beginning of a global liquidity regime, which will also prove costly for some banks.

All this amounts to a very major change in the framework of capital regulation. So the committee has given the banks until 2018 to implement the new requirements in full, though it is clear that some countries may well accelerate progress toward that goal. The committee has adopted what might be called the “St Augustine” approach: in other words, it would like to make the banking system much safer, more chaste if you like—but not yet.

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Further reading

Article:

  • Modigliani, Franco, and Merton H. Miller. “The cost of capital, corporation finance, and the theory of investment.” American Economic Review 48:3 (June 1958): 261–297. Online at: www.jstor.org/stable/1809766

Report:

  • Basel Committee on Banking Supervision. “Countercyclical capital buffer proposal.” Consultative document. Bank for International Settlements, July 2010. Online at: www.bis.org/publ/bcbs172.htm

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