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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.