This article was first published in Quantum magazine.
The latest Basel incarnation is, to the consternation of the banks, heading inexorably towards a more onerous rulebook, says Brian Caplen.
Developing the New Regulations
The problem with making rules for banks is that it invites these institutions to find ways round them. In some ways the more simple the rules, the more effective they may turn out to be, as they are easier to supervise and more difficult to subvert. In that sense the first version of Basel (agreed by the Basel Committee, the Swiss-based supervisory forum, back in 1988), with its basic 8 per cent capital approach, had its merits.
Indeed, the most robust advocates of the free market argue that the best approach to bank regulation is to abolish the rules altogether. Instead, let investors and depositors judge the banks for themselves and allow those that get into trouble to collapse. In reality Basel
is moving in the opposite direction and there is an inexorable move to a more onerous and pervasive rulebook. With the Basel framework – in any of its previous formats – having failed to prevent the financial crisis, the Basel Committee has now moved a long way from the simple approach.
Basel III, the latest incarnation released in December 2010 and due to be implemented from 2013 onwards, is hugely complicated. It sets out a host of new measures to raise the quality and consistency of the capital base, as well as introducing new standards on liquidity and funding. All this comes on top of Basel 2.5, agreed in July 2009, which proposed measures to reduce the risks involved in securitisation and the trading book.
This tough new approach presents three difficulties. Firstly, in trying to make the banks safer, there is a danger that it will have a negative impact on the global economy by slowing global growth. The effect of higher capital ratios is to reduce lending capacity, and there are fears that new rules on trade finance (even with the October 2011 revisions) could prove highly disruptive to international commerce. Secondly, there is the question of how supervisors will implement the rules. Will different supervisors interpret them in different ways and will there be backsliding in some jurisdictions?
Finally, there is the critical question of whether banks will find new ways to game the system. It was, after all, the original Basel approach to on-balance-sheet capital that led banks to build off-balance-sheet securitisations of subprime mortgages (as a way of expanding outside the guidelines). For the most part supervisors ignored these, until they ultimately came crashing down and caused the financial crisis.
Now there are to be new more complicated rules. These provide the banks with even greater scope to operate them in ways that were unintended and that, ultimately, means they may have harmful consequences. Banks need to make profits, and it is only natural that they should construct their businesses to take advantage of the new proposals.
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