Is the Basel process broken? You can bank on it

Earlier this week, Stefan Ingves (left), chairman of the Basel Committee on Banking Supervision’s governing body, and Mervyn King announced amendments to Basel III’s liquidity rules for banks. AAP

This year, the Basel process of banking regulation is 25 years old. In 1988, the first set of global banking regulations, known as Basel I, was adopted by the world’s senior banking regulator, the Basel Committee on Banking Supervision (BCBS), which is based in the Swiss city of the same name. There have been three major (and a few minor) iterations of Basel proposals since 1988: Basel II in 2004 and Basel III, which was approved in 2010 after the GFC but revisited only this week.

Pronouncements from the Basel Committee tend to be written in impenetrable, bureaucratic jargon. For example, the latest announcement is titled “Group of Governors and Heads of Supervision endorses revised liquidity standard for banks”. It could just as easily been labelled “After talking about this for two years, we have given into the banks, yet again”. To use the terminology of the ‘fiscal cliff’, regulators have “kicked the can” down the road, postponing final implementation of a critical component of Basel III, the so-called liquidity coverage ratio (LCR), until 2019 - a lifetime in the financial markets.

Before discussing this latest climb-down, it should be noted that the Committee has form in this respect.

A short history will illustrate how the Basel process has evolved. The first Basel proposal was relatively benign, requiring banks to maintain minimum levels of regulatory capital at a ratio of 8% of their credit risk- weighted assets. This meant that for each $100 of loans, banks had to retain $8 dollars against potential losses. This figure of 8% was arrived by a tortuous committee process that was far from transparent. After agreement, it was decreed that the banks covered by the initial rule would comply over a three-year “transition” period.

One might ask: why would implementation take three years?

Even though the calculation of the minimum capital required was — in the Committee’s own words — “simple”, in practice banks were forced to develop new computer systems and accounting processes to collect the data needed to do the relatively straightforward calculations. This scenario of rule-making, followed several years later by partial implementation is a recurring theme of Basel regulations.

In its first iteration in 1988, Basel I applied only to traditional assets, such as loans, which were “on balance sheet”. “Off-balance sheet” items such as currency and interest rate derivatives were not considered. In 1995, however, the venerable British bank Barings collapsed. Regulators were shocked to discover that these new-fangled derivatives could actually bring down a functioning bank. Reacting late as usual, the Committee hurriedly proposed a new set of rules on the capital required to cover so-called “market risks”.

In 1996, the so-called Market Risk Amendment to Basel I was agreed by the Committee with a new concept, known as value at risk (VAR), embedded in the regulations. The concept of VAR has been the subject of much debate in the academic literature as to its usefulness as a robust measure of risk. Of concern was that fact that VAR does not give a reliable indication of what can occur in an extreme “black swan” situation. However, despite the obvious drawbacks, VAR became the standard for calculating market risk capital, with disastrous consequences later.

The 1996 Amendment marked a seachange in banking regulation that was not fully apparent at that time. In addition to decreeing a supervisory formulae for each type of derivative (the “standardised model”), the Committee introduced a new concept — the “internal model” — by which a bank could use its own internal calculations to estimate the capital that they needed. In other words, the inmates (i.e. the largest banks) had been allowed to take over the asylum, or at least the Basel capital calculation process. Regulators moved from their traditional role of setting strict limits on banking activity to becoming mere checkers of banks’ own internal models. This was an arms race that regulators were always going to lose, as banks had more money than regulators to buy computers and hire rocket scientists (literally) to develop mind-boggling mathematical models, which, as the GFC illustrated, often worked poorly in practice.

In 1999, the Basel Committee announced plans to introduce a new capital adequacy framework, which became known as Basel II. The Committee argued that Basel II was necessary because the banking industry had developed risky products that were not covered by Basel I. Boy, were they right!

For the next five years, the Committee toiled to agree on Basel II rules and, in 2004, produced the “revised framework”, a 239-page document that is utterly incomprehensible, filled with complex formulae for which no theoretical underpinning was ever provided. After four more years and billions of dollars spent complying with new rules, Basel II was implemented in 2008 in some of the world’s largest banking markets. Interestingly, the USA was not one of them.

But by the time that Basel II was finally implemented, it was already too late. Basel II was overtaken by the global financial crisis (GFC), which was exactly the type of credit-related calamity that Basel was meant to prevent. The Basel capital regime failed as supposedly well-capitalised banks (at least according to their own models) had to be bailed out by taxpayers and sovereign wealth funds. All sorts of risks that had been excluded from Basel rules — such as liquidity risks — had torpedoed some of the largest banks in the world, costing taxpayers billions.

Basel was not responsible for the GFC, but it was as useful as an umbrella in a hurricane. During the crisis, when it should have been in the forefront of efforts to tackle the crisis, the Basel Committee was missing in action, while bodies such as the G-20 and the IMF rolled up their sleeves to tackle the problems caused by the obviously insufficient banking regulations developed in Basel.

When the hubbub died down, the Basel Committee did what it does best, which was to issue new rules to fight the last war. In 2010, the Committee unveiled Basel III, which in itself is not an unreasonable set of rules to force banks to maintain capital to cover an increased range of risks such as liquidity risks. Unfortunately, Basel III still does not address some of the key root causes of the GFC, such as the shadow banking problem, or what to do about firms such as hedge funds, whose activities can undermine regulated banks.

What is really depressing about Basel III, is that, before the ink has even dried on the new rules, the world’s largest banks, aided often by their own governments, have found ways around the new rules. Australia is a good example.

Even Australia has found a way to circumvent Basel III regulations. AAP

During the GFC, a number of failed banks, such as Northern Rock and Lehman Brothers, ran out of ready cash to pay the bills - in banking terms, they lacked liquidity. One of the more sensible rules in Basel III is for banks to be forced to maintain sufficient highly liquid assets (HLA), such as government bonds, to tide them over a crisis. The idea is that banks could, in a crisis, sell HLAs to keep them going for about one month, or at least long enough for the government to come up with a plan to bail them out.

So far, so good. But nothing is as easy as it seems, at least where Basel is concerned. Due to successive governments’ aversion to issuing government debt there is, in Australia, a distinct shortage of high-quality HLAs. So what to do? Should we force Australian banks to cut back their highly profitable activities today to comply with foreign banking regulations?

Enter the Reserve Bank of Australia (RBA). In a recent speech, Assistant Governor Guy Debelle described a rabbit, the so-called committed liquidity facility (CLF), that had been neatly pulled out of the RBA’s hat. Stripped of technical twaddle, the CLF means that the taxpayer (in the guise of the RBA) will act as pawnbroker to the big banks when they are short of readies, taking whatever dross they have on their books and giving them cash to tide them over. With backing like that and the promise of an implicit government guarantee, is it any wonder that Commonwealth Bank’s market capitalisation has just topped $100 billion, pushing it into the list of top 10 banks by market capitalisation in the world?

If Australia is prepared to bend the rules to protect the profitability of the biggest banks, what can be expected of less trustworthy jurisdictions?

After 25 years, it is about time that the question was asked: is Basel doing a good job, and is that job worth doing?

The history of Basel shows that the process of developing robust regulations to prevent international banks failing is broken. The Basel process lacks transparency and accountability and has been captured by the very firms and governments that it is trying to regulate. It is based on inexplicable agreements that are arrived at through a convoluted committee process, producing results that take several years and millions of dollars to implement. The Basel bureaucrats are not evil or incompetent, but are simply outgunned by the bankers, who can afford to keep lobbying until rules are watered down and implementation is delayed.

Basel is broken. We needn’t wait until 2019 — or another GFC — for this to be confirmed.