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Meet Basel III

What’s at stake: In one of the most significant reforms to global finance to emerge from the Great Recession, regulators from around the world agreed to new standards for banks on Sunday, called Basel III. The rules are aimed at making the world’s financial system safer and less susceptible to the sort of recession-inducing meltdown […]

By: Date: September 20, 2010 Topic: Banking and capital markets

What’s at stake: In one of the most significant reforms to global finance to emerge from the Great Recession, regulators from around the world agreed to new standards for banks on Sunday, called Basel III. The rules are aimed at making the world’s financial system safer and less susceptible to the sort of recession-inducing meltdown we endured in 2008 by requiring banks to maintain stronger balance sheets. This agreement should be confirmed by the G20 in November.

The package

The Basel Committee press release gives the important details on the reform’s substance and its implementation dates. The package sets a new key capital ratio of 4.5 per cent, more than double the current 2 per cent level, plus a new ‘conservation buffer’ of a further 2.5 per cent. Banks whose capital falls within the buffer zone will face restrictions on paying dividends and discretionary bonuses. In addition to the 4.5 per cent so-called core tier one ratio – which will begin implementation from 2013 to 2018, and the 2.5 per cent conservation buffer – which will be implemented no later than 2019, the reform package also endorses the idea of an additional buffer of up to 2.5 per cent of core tier one capital to counter the economic cycle, although the details on this remain sketchy. The report also notes that systemically important banks should have loss absorbing capacity beyond the standards announced but nothing has yet been finalized on this.

For more, see this handy PDF chart of the new capital requirements, and this PDF chart of the implementation table. Felix Salmon a great write-up. Richard Smith at Naked Capitalism has more.

Does Basel III address the failures of Basel II?

Zach Carter writes that a 31-to-1 leverage brought down Lehman Brothers, and Basel III will permit 33-to-1 leverage. By 2007, the official leverage ratio that Lehman Brothers reported to the public was 31-to-1 (see page 29 of their 2007 annual report). Despite lots of new tables about risk-weighted assets and Tier 1 capital, the only hard new leverage rule we have from Basel is a straight cap at 33-to-1. So the new standards would leave plenty of room for the crazy risk-taking that brought down Lehman Brothers. The new Basel capital standards are indeed a step forward – but that says more about how pathetic the current capital standards are than about how great the new rules are.

Free exchange argues that Basel III doesn’t address the calculation of risk-weights which was the principal contribution of Basel II to the last financial crisis. One of the key components of Basel II was to increase the amount of capital banks had to hold against riskier assets. Extremely low-risk assets, meanwhile, could be held with very little or even no capital. Risk, moreover, was calculated primarily by reference to the rating assigned by one of the recognised ratings agencies. The consequence of this Basel II reform was to discourage banks from lending to risky enterprises, and to encourage the accumulation of apparently risk-free assets. This was a primary contributor to the structured finance craze, as securitisation was a way to "manufacture" apparently risk-free assets out of risky pools. Since it did not change this risk-weighting, 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 leveraged much more highly than risky assets.

Eurointelligence reports that the FT has a counterintuitive article on Basel III that shows that the actual impact of the new regime is likely to much larger than the headline would suggest, because of the more discrete hidden rules. For example, goodwill, tax credit and minority investments can no longer be counted as profits, and thus form no longer part of core capital. According to the estimate, some banks would see their tier 1 capital reduce by 30 to 40 per cent. All in all, the rules produce an effective increase in minimum capital requirements is from 2 to 10 per cent.

Mike Konczal highlights the importance of the countercyclical buffer, which requires banks to hold more capital in good times and as the economy is expanding, check out this chart from the Boston Fed. As the housing bubble was getting into its worst phase in 2005 you can see many of the major investment banks take on higher leverage and hold less capital. Under Basel they’ll have to lean against that, which is a very wise move for stability and soundness concerns.

Liquidity reserving

Stephen Lewis of Monument Securities argues that the liquidity standard that the Basle committee is proposing will be more relevant to heading off a re-run of 2007-09 than changes in the banks’ capital requirements. After all, most banks remained solvent through the crisis without government help to shore up their capital. What led these banks to rein back their lending to the broader economy, with dramatic impact on general business activity, was the spreading illiquidity that caused money markets to seize up. If banks had held more liquid assets going into that time of stress, and had been less dependent on wholesale funding, they might not have felt so keenly a sense of urgency in cutting back loan exposures.

Economics of contempt has a useful summary of the Basel III liquidity requirements. The Basel Committee has made a new liquidity regime a focus of Basel III. The new liquidity regime can be found in the December 2009 consultative document as amended by last month’s Annex. The main component of Basel III’s liquidity regime is the Liquidity Coverage Ratio (LCR), sometimes known as the "Bear Stearns rule." The LCR requires banks to maintain a stock of "high-quality liquid assets" that is sufficient to cover net cash outflows for a 30-day period under a stress scenario. 

Is the transition period too long?

Mark Thoma argues that the pace at which the capital adequacy ratios are being implemented – they won’t be fully in place until 2018 – may not be fast enough to avoid trouble in the interim. The rules are intended to give banks the time they need to adjust, but the financial sector is noted for its flexibility in responding to unanticipated shocks, and they ought to be able to cope at a faster rate than this. Martin Wolf further argues that the long transition period renders the deal nearly pointless since a new financial crisis will occur before then.

Ezra Klein thinks it is wise for Basel III to phase in progressively: the best time for banks to have high capital requirements is right before a crisis, but the worst time is right after one. If banks have to raise capital, they don’t make loans. And if they don’t make loans, the economy can’t recover. We’re actually seeing a bit of that now, so I’m happy to see Basel move slowly.

From international agreement to national rules

Charles Wyplosz points out in Telos that international agreements are great, but they’re not binding. For Mike Konczal implementation of Basel III is not a done deal, and clever future administrations can monkey around with it in all kinds of ways. Ezra Klein points out that the US administration didn’t enforce Basel II, and though we’re likelier to implement Basel III, as it’s coming at a moment when regulators want to be strict rather than lax, it’ll be easier to wiggle out of 20 or 30 years from now when the economy is booming again and everyone feels confident.

Simon Johnson argues that the United States and other countries with major financial centres will need to pick up the slack and add substantial additional capital requirements at national levels if these new rules are to be effective. The best chance — and perhaps the only one remaining — is for the United States to insist on stronger capital requirements for domestic financial institutions, as permitted, even encouraged, in Basel III under the heading of “countercyclical buffer.” And systemically important financial institutions, for which the Basel process appears to have completely dropped the ball, should be subject to even higher requirements. This should be coordinated with Britain (where there is already thinking in the right direction), Switzerland (again, forward-thinking officials hold sway), and anyone else who can be brought on board.

Does it significantly change the growth/stability trade-off?

The banks insist that holding more capital would slow lending and therefore slow the real economy. The global banks’ Institute for International Finance issued a report in June that insisted on this point claiming that the costs of new capital and liquidity standards would be to reduce growth rate in the US, eurozone and Japan by about 0.6 percentage points a year between 2011 and 2015. Over 10 years, it reckoned the new standards would cost 3 per cent of output. That is quite a hit, although smaller than the economic losses from the economic crisis. The institute went on to estimate that about 9.7 million fewer jobs would be created as a result.

Simon Johnson reports that the most readable counterarguments come from a paper by Sam Hanson, Anil Kashyap and Jeremy Stein (reviewed here recently). In recent months it has become clear that – behind the scenes and off the record – a growing number of important officials agree broadly with this view. The Bank for International Settlements itself has produced two serious assessments that, if you look at them carefully (and this is not light reading), argue strongly that longer-term growth would benefit from higher capital requirements, because we would experience fewer mega-crises, and the transition to such arrangements would be much smoother than the industry contends. Stephen Cecchetti, Bank for International Settlements chief economist, the IIF makes no allowance for cheaper equity capital once banks are safer from collapse. They have assumed no changes in dividends, compensation policies and operational efficiency, nor have they taken account of the benefits coming from a more resilient financial system, including the lower funding premia that safer banks need to pay. The UK National Institute of Economic and Social Research has some results which are remarkably similar to those from the BIS.

Impact on emerging markets

FT Beyond BRICs notes that although the debate over new capital reserve rules at the Basel Committee on Banking Supervision has been dominated by fights between the US and Swiss on the one hand and Germany on the other, the global standards apply worldwide and could affect the long-term shape of banking in emerging markets. These requirements will not be onerous for many emerging market banks. As of last week, most of the big banks in India and China held core tier one ratios well above 9 per cent, and deductions were not expected to shave more than about 1 per cent off their totals. Another part of the Basel III package could prove be more onerous, as it requires banks to hold enough cash and government bonds to get them through a 30-day market crisis. This “liquidity coverage ratio” is problematic for banks in countries without liquid government bond markets.

*Bruegel Economic Blogs Review is an information service that surveys external blogs. It does not survey Bruegel’s own publications, nor does it include comments by Bruegel authors.

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