Basel III will probably be worth defending
Once one becomes a critic it is usually better to remain one (press and conference organisers enjoy it that way). But as the new accord on international banking, popularly referred to as Basel III, is definately not perfect, it is on the right course and requires defending against attempts by bankers and their friends to cut it down, dilute it, and postpone it.
Bankers want us to believe that weak bank lending pertains to tight and/or uncertain regulation. This is a seductive argument for politicians in Europe and the united states as growth dries up and elections loom. But lending is weak because many borrowers are repairing their balance sheets and repaying loans. Numerous others are no more creditworthy.
Basel III reforms represent a reorientation of regulation in the proper direction; it reflects many lessons learned plus some errors checked. The sooner the brand new rules are adopted, the sooner banking can shift to a far more sustainable path, but once again banks are putting themselves at risk by trying to frustrate the procedure.
Financial crises are so complex with so many apparent causes that within their aftermath there is absolutely no shortage of clever solutions searching for a problem. Reforms are best measured by if the problem they solve or address, if solved earlier, could have limited the crisis or, merely deflected it to another thing with little overall difference. The financial meltdown revealed five substantive issues that ought to be solved.
- First, we were once again reminded that booms are fuelled by an underestimation of risks.
From the perspective of the ‘after-party’, banks lent an excessive amount of, too rapidly, and with an excessive amount of leverage. This behaviour was self-feeding as lending pumped up asset prices justifying further leverage. It had been accelerated by the market-sensitive risk management approach and fair value accounting promoted by Basel II, in the name of Nobel-prize-winning sophistication and market discipline (see Persaud 2000).
- Second, banking regulation cannot fight the excesses of the credit cycle alone.
Monetary and fiscal policy must are likely involved. As the shortcomings of monetary policy in addressing a boom in a single or two sectors are well recognised, the need for fiscal policy is all too often forgotten. Overly loose fiscal policy in america following the dotcom-bubble burst was a bigger contributory factor to the excessive consumption and overvalued dollar that fed the boom than monetary policy.
Regulatory policy must, at the minimum, not amplify the credit cycle which is what Basel II did. The Basel Committee responded with limits on leverage (the ratio of lending to equity) and countercyclical capital reserves made to curb the enthusiasm for lending near the top of the economic cycle. I’d argue for a straight lower leverage ratio – say twenty times capital – and larger countercyclical provisions; but given Basel II had put all its faith in procyclical, market-sensitive risk-weightings, that is an excellent start, in the proper direction.
- Third, given the natural tendency of banks to underestimate risks in a boom, Basel II was too kind to large banks, permitting them to use their own internal risk systems to create lower regulatory capital, encouraging these systemically important institutions to grow consistent with their own hubris.
Basel III responded with higher capital costs for systemically important institutions, better internalising the risks their size poses to the economic climate. It is doubtful these additional charges are big enough to improve lending behaviour, but given Basel II had previously been shackled from doing this by the self-imposed imperative of ‘level playing fields’, this is a good part of the proper direction. Recent research on the result of higher capital adequacy ratios on lending claim that bankers do protest an excessive amount of (see Miles et al 2011).
- Fourth, the derivative markets have far outgrown their cash markets.
That is less worrisome than many feel within their bones. It really is nonetheless an authentic problem in the fog of crisis. Whenever the large derivative markets encounter an emergency, problems arise from the actual fact that there surely is uncertainty concerning where vulnerable positions are and how they are being unwound and netted off.
The Basel Committee responded, within an admirably measured way, by supporting new rules on mandatory trade reporting and incentivising the central clearing of most trades. Putting all exposures on balance sheet would also help, but to be fair that had been part of Basel II – implementation was just too slow. I really believe a small transactions tax also may help in limiting the production of systemically risky but socially questionable financial turnover.
- Fifth, this is an emergency of funding liquidity.
Basel II largely ignored liquidity so the banks were incentivised to borrow cheaply from the markets instead of expensively from customers. This business design boosted profits through the calm time, but market liquidity is ephemeral so when things turn tricky it vanishes. This might have resulted in an economy-wide insolvency if banks were then forced sell all their illiquid securities concurrently – which explains why the central banks had no alternative but to part of. Those who think that authorities must have stood still and allow banks fail have little history on the side to aid such a courageous position.
Basel III has responded with a simple reform that will require banks to be better insulated from periods of financial market illiquidity and requiring an improved matching of maturities of lending and borrowing. This latter proposal has elicited the best protests from banks and implementation has been kicked later on till 2018. Bankers argue that borrowing short and lending long is what banks do. The right response ought to be: “Exactly!” Most financial crises are rooted in liquidity problems in the bank operating system.
The nature of the crisis has meant that ‘credit risk transfer’ sometimes appears as the villain of the peace, but we are at risk of throwing out the infant with the bath water. As Professor Charles Goodhart has bravely remarked, among the underlying problems of the crisis was that there is insufficient risk transfer, merely the transfer of illiquid assets off the total amount sheet of the same institution.
The economic climate will be safer if illiquid assets flowed out from the bank operating system towards insurance and pension funds and liquid assets flowed the other way. The principal-agent problem, where banks that originate debt to be able to sell it on aren’t incentivised to value the quality of your debt, is real enough, though at risk of being exaggerated, and may be managed by shifting bank remuneration because of this activity from up-front origination fees to annual fees associated with the performance of your debt. Among the obstacles to a systemically safer allocation of risks is that the brand new regulation of holders of long-term liquidity like insurance and pension funds (Solvency II) discourages them from owning illiquid assets through increasing focus on market-sensitive value accounting and short-term solvency ratios. The one thing worse than Basel II was Solvency II.
To lessen systemic risks, individual risks have to be able to proceed to where they could be better absorbed. The name of the overall game is optimal risk allocation over the financial system. It isn’t about getting in just how of risk transfers by adding barriers and lobotomising the economic climate.
The true problem with Basel III is that the chance – presented by the crisis and the creation of the Financial Stability Board – for joined-up regulation in the name of better managing risk at the system-wide level had not been grasped.
Grandly sounding systemic risk committees made up of the same individuals who missed the crisis to begin with isn’t a satisfactory response. But why don’t we at least make sure that those conditions that were grasped by Basel III aren’t abandoned through pressure from banks arguing that the brand new regulations are the reason behind weak lending.
In reality, Basel III can be an overdue step in the proper direction.
Miles, David, Jing Yang and Gilberto Marcheggiano (2011), “Optimal bank capital”, External MPC Unit, Discussion Paper 31.
Persaud, Avinash (2000) “Sending the herd off the cliff edge: the disturbing interaction between investor herds and market-sensitive risk management systems”, IIF, Washington 2000
1 “Banks put themselves at risk in Basel”, October 2002.