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.

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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.