Sunday, April 20, 2014
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Better than Basel

ROME – The Basel Accords – meant to protect depositors and the public in general from bad banking practices – exacerbated the downward economic spiral triggered by the financial crisis of 2008. Throughout the crisis, as business confidence evaporated, banks were forced to sell assets and cut lending in order to maintain capital requirements stipulated by the Accords. This lending squeeze resulted in a sharp drop in GDP and employment, while the sharp sell-off in assets ensured further declines.

My recent study with Jacopo Carmassi, Time to Set Banking Regulation Right, shows that by permitting excessive leverage and risk-taking by large international banks – in some cases allowing banks to accumulate total liabilities up to 40, or even 50, times their equity capital – the Basel banking rules not only enabled, but, ironically, intensified the crisis.

After the crisis, world leaders and central bankers overhauled banking regulations, first and foremost by rectifying the Basel prudential rules. Unfortunately, the new Basel III Accord and the ensuing EU Capital Requirements Directive have failed to correct the two main shortcomings of international prudential rules – namely, their reliance on banks’ risk-management models for the calculation of capital requirements, and the lack of supervisory accountability.

The latest example highlighting this flaw is Dexia, the Belgian-French banking group that failed in 2011 – just after passing the European Banking Authority’s stress test with flying colors. The stunning opacity of solvency ratios encouraged regulators to turn a blind eye to banks’ excessive risk-taking.

The problem is that the Basel capital rules – whether Basel I, II, or III – are of no help in separating the weak banks from the sound ones. Indeed, more often than not, the banks that failed or had to be rescued in the wake of the 2008 financial crisis had solvency ratios higher than those of banks that remained standing without assistance.

Compounding the problem, the diversity in banks’ capital ratios also indicates a dramatic distortion of the international playing field, as increasingly competitive conditions in financial markets have led to national discretion in applying the rules. Meanwhile, the opacity of capital indicators has made market discipline impossible to impose.

Thus, large banks are likely to continue to hold too little capital and to take excessive risks, raising the prospect of renewed bouts of financial instability. In order to overcome these shortcomings in international banking regulations, three remedies are needed.

First, capital requirements should be set as a straightforward ratio of common equity to total assets, thereby abandoning all reference to banks’ own risk-management models. The new capital ratio should be raised to 7-10% of total assets in order to dampen risk-taking by bankers and minimize the real economic impact of large-scale deleveraging following a loss of confidence in the banking system.

Second, new capital ratios with multiple and decreasing capital thresholds, which trigger increasingly intrusive corrective action, should serve as the basis for a new system of mandated supervisory action. Supervisors should be bound by a presumption that they will act. They could argue that action is not necessary in a specific case, but they would have to do so publicly, thus becoming accountable for their inaction. In order to eradicate moral hazard, the system must have a resolution procedure to close banks when their capital falls below a minimum threshold.

Finally, solvency rules should be complemented by an obligation that banks issue a substantial amount of non-collateralized debt – on the order of 100% of their capital – that is convertible into equity. These debentures should be designed to create a strong incentive for bank managers and shareholders to issue equity rather than suffer conversion.

These three measures, if applied to all banks, would eliminate the need for special rules governing liquidity or funding (which would remain open to supervisory review, but not to binding constraints). There would also be no need for special restrictions on banking activities and operations.

The most remarkable feature of the policy deliberations on prudential banking rules so far has been their delegation to the Basel Committee of Banking Supervisors and the banks themselves, both of which have a vested interest in preserving the existing system. Governments and parliaments have an obligation to launch a thorough review of the Basel rules, and to demand revisions that align them with the public interest.

Read more from our "The Big Bank Theory" Focal Point.

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  1. CommentedLudwig van den Hauwe

    One can always say, in retrospect, that a bank that runs through its usable capital cushion was overleveraged, but one of the mysteries with respect to the financial crisis is that the banks, even when they were accumulating relatively low-yielding PLMBS/CDOs because of the capital relief they offered under Basel I and the Recourse Rule, apparently weren´t using this capital relief to increase their leverage, which remained steady (in the aggregate) during the years before the crisis. One possible answer is that banks, by using capital arbitrage to obtain capital relief, were expanding their "extra" prudential capital cushion by lowering the legally mandated capital floor (keeping their leverage levels steady) since capital devoted to the extra cushion is necessary in the face of an unpredictable future, while capital devoted to the legal cushion is wasted, or at least, its buffer function is limited. And of course the ultimate causes of the crisis lie deeper; as long as the financial and monetary sectors are organized along collectivist planning principles, there will be crises and recessions...

  2. CommentedRoman Bleifer

    The banking system is not an isolated individual sector of the economy. Banking system of the stock markets are like communicating vessels. You can not adjust the level in one of the vessels by the same rules, and the level in the other by different rules if those rules are not compatible. Because of this, attempts to remove the banking sector, the speculative component of the system without changing the stock markets are doomed to failure. The present system of stock market works on itself, and not on the real economy. And the economy can not develop without a reliable system of redistribution of investment. The situation is close to a deadlock and no systematic change in this area has no solution. ( ) If these changes do not hold consciously, it will make the global crisis. but then the way is through a huge collapse of the stock market itself.

  3. CommentedGraham Hodgson

    Regulation of banks now focuses primarily on bank solvency, the adequacy of their assets for backing banks' liabilites to their depositors. But assets come under strain because of the requirement on banks to engage in a daily scramble for liquidity through the inter-bank lending markets to meet their payment settlement obligations to their customers. This is a system which evolved in the days when scarce gold was the means of final settlement and what little there was had to be kept in constant circulation within the payments system. But final settlement is now through central bank reserves and there is no physical constraint on the availability of these. The crisis-prone banking system would be rendered immediately more robust by removing customers' transactions accounts (demand deposits) from banks' balance sheets and relocating them directly to the central bank, with commercial banks being charged with merely administering these accounts on their customers' behalf.

  4. CommentedProcyon Mukherjee

    A brilliant article that summarizes the essence of banking leverage and how public interests could be balanced. I am attracted to the final remedy that has been prescribed, which directly works against the fundamental driver of risk behavior in banks, Return on Equity. By one to one conversion of debt to equity it is this parameter that would be impacted most, and which Bank Management had tried to diligently work on as bulk of the incentives are tied to preserving the lower value of the denominator, rather than the increased value of the numerator in the ROE.

    Procyon Mukherjee