Why Basel III won’t protect banks from another global crisis

Not too big to fail: the Basel III doesn’t solve some fundamental problems of Basel II. AAP

The global financial crisis revealed the inadequacy of Basel II capital requirements for banks and exposed its loopholes.

As a result, the Basel Committee on Banking Supervision (BCBS) has come up with proposals to “overhaul” Basel II, so that it can deal with a future crisis of the magnitude of the global financial crisis.

These proposals, which constitute what is commonly known as Basel III, are unlikely to be adequate for dealing with anything of the magnitude of the global financial crisis, let alone something bigger.

The first proposal is concerned with the quality, consistency and transparency of the capital base to ensure that high-quality capital is present to absorb losses.

Redefining capital to exclude items that do not remotely represent or resemble capital is a positive move.

However, redefining capital does not solve the problems associated with the calculation of the capital ratio on the basis of risk-weighted assets.

The risk weights are arbitrary, and the whole system boosts the procyclicality of the banking industry without solving the problem of regulatory arbitrage.

The proposal to widen risk coverage is meant to strengthen the risk management of counterparty credit exposure. This sounds good but there are problems.

To control counterparty risk in derivatives, an effective course of action is to force (rather than beg or provide incentives for) the trading of derivatives on organised exchanges or to require a full financial back-up of transactions.

Regulators should learn from the lessons of the late 1990s when Brokesley Born, the then head of the Commodity Futures Trading Commission (the US agency in charge of regulating derivatives), made some serious suggestions to regulate OTC derivatives.

Unfortunately, Born’s proposals (which could prevent the recurrence of an AIG-type mess) did not see the light because of opposition from the trio of Larry Summers, Alan Greenspan and Robert Rubin (at least two of them have “reformed” their thoughts since the global financial crisis).

A leverage ratio is to be introduced as a “supplementary” measure to the Basel II risk-based framework. However, it is rather strange to suggest that the leverage ratio is a “supplementary” tool, given that when a leverage ratio is in place, it implies a corresponding capital ratio.

Leverage and capital ratios are not supplementary. Indeed they are equivalent, unless the capital ratio is measured on the basis of risk-adjusted assets rather than total assets.

Without a leverage ratio it is possible for banks to hold a small amount of capital versus the unweighted balance sheet, which has been symptom of a banking culture with a greater willingness to take on more risk with depositors’ and taxpayers’ money.

The leverage ratio is more objective, easier to calculate and more readily understandable than the risk-adjusted capital ratio.

Countercyclical capital buffers will be introduced to promote the build up of capital in “good times” that can be drawn upon in periods of stress (“bad times”), hence reducing the procyclicality of the banking industry.

The problem is that identifying “good times” and “bad times” is subjective at worst and rather difficult at best. There is no way of coming up with a figure for the capital buffer that will absorb losses in bad times.

It is some sort of “Mission Impossible” to calculate (basic) regulatory capital Basel-style, which makes the task of calculating countercyclical capital buffers “Mission Impossible 2”.

The bottom line is that the banking industry is procyclical, and no-one can change this fact of life. But at least we know what not to do—that is, boosting the procyclical tendencies of the banking industry, which is what Basel II does and what Basel III will also do.

The objective of the liquidity proposal is to introduce a global liquidity framework that establishes minimum standards for funding liquidity risk.

While the regulation of liquidity is a step forward, because low liquidity hampers business and may induce bank runs, the proposed liquidity provisions are rather complex in the sense that the liquidity ratios are difficult to measure.

More seriously, the provisions are based on liabilities rather than assets, which is inappropriate.

Instead, a simple asset-based liquidity ratio can be used to supplement the leverage ratio. A liquidity ratio may be set in terms of deposits, total liabilities or current liabilities, with a clear-cut listing of liquid assets.

Another useful liquidity indicator is the funding gap, the difference between loans and deposits.

In short the Basel III proposals do not deal with some of the most fundamental problems of Basel II: allowing banks to use internal models to calculate regulatory capital, reliance on rating agencies, the implementation problems, and the exclusionary and discriminatory aspects of Basel II.

Regulation should cover banks and non-bank financial institutions because banks deal with insurance companies and hedge funds to shift promises, which enables them to raise leverage and reduce capital.

Furthermore, there are no provisions in Basel II for resolution regimes, which leaves a lot to be desired with respect to the (big) problem of “too big to fail”.

The question that remains is whether or not the way forward should be led by the Basel Committee, in the sense that the required regulatory changes are introduced as a Basel accord and implemented worldwide.

This may not be the right thing to do because it has become quite clear that international harmonisation of banking regulation does not work.