Last week in Seoul the Basel Committee on Banking Supervision (BCBS) presented the G20 with a new set of capital and liquidity standards for the banking industry. For its part, the G20 has pledged that it will begin implementing of the so-called Basel III agreement as early as the beginning of next year. This represents an ambitious attempt to shore up the vulnerabilities in the banking sector that lead to the recent crisis.
New rules…
However, while this is a move in the right direction, there are still two issues that have to be resolved before Basel III can be called a success. First, the new liquidity and capital standards have to be enacted. They will do little good unless they are consistently adopted and enforced across jurisdictions. This could prove problematic since the new provisions may face opposition from both domestic legislatures and banking industries. Second, Basel III has called for higher standards for so-called Systematically Important Financial Institutions (SIFIs). Unfortunately, it has not yet indentified what these higher standards are and which SIFIs they apply to.
In terms of the proposal it presented to the G20, the Basel Committee has outlined an ambitious set of standards which aims at improving the quality of bank capital, liquidity standards, and the coverage of risks. These measures include a call for stronger industry supervision and risk management through a strengthening of the Pillar 2 provisions of Basel II. They also increase the Pillar 3 standards of disclosure on complex financial transactions.
Two of the new measures are particularly important. First, Basel III has increased the minimum common equity that banks must to hold to 7%. This consists of an increase of the common equity requirement to 4.5% and an additional capital conservation buffer of 2.5%. This is a dramatic increase from the 2% required under the Basel II agreement.
Second, the new measures also contain provisions to ensure the procyclicality of the new capital requirements. This essentially forces banks to increase their capital levels in boom times by as much as 9.5% of risk-weighted assets. The goal of this provision is to both avoid asset bubbles in good times and to ensure adequate capital reserves in bad times. One notable aspect of this is that if capital levels fall below the 2.5% conservation buffer, banks are automatically required to suspend all distributions. This is to avoid market pressure to maintain the payment of dividends and bonuses when a bank is facing potential solvency issues.
… meeting with cool reception from the industry
While these measures will increase the safety of balance sheets, they have raised concerns in the banking industry. The fear is that Basel III will weaken profits, the volume of lending, and employment. In fact, this is an unavoidable aspect of any increase in banking regulation. The real issue, however, is whether the increase in safety outweighs the cost in terms of lower profits and diminished economic activity. The BCBS has argued that the cost of Basel III will be small compared to the benefits. However, there is still no clear indication of the ultimate impact of the new regulations. The argument can also be made that credit has been too cheap during the last decade. This was one of the primary catalysts of the recent crisis. Thus, increasing the cost of lending may in fact be desirable.
This issue ultimately comes down to what kind of banking industry policymaker want. In financial markets there is always a trade off between stability and growth potential. Risk can be decreased by making capital and liquidity requirements more stringent, but this necessarily decreases lending opportunities for banks. For regulators, a less profitable but more stable banking system is preferable. Bankers, on the other hand, tend to be much more concerned with their ability to provide financial products and take advantage of innovation and growth opportunities. Currently, the G20 has erred on the side of stability. The question is whether in the long run this will remain the case. In particular, once prosperity returns, the Basel III provisions may seem like breaks rather than support to international economic prosperity.
The need for a suitable timesheet, to preserve fair competitiveness
The real test of Basel III lies in its implementation. The Seoul communiqué outlined the following timetable. Work on translating the new framework into national laws and regulation will begin next year. Implementation of the new regulations will begin on January 1, 2013. It will be fully phased in by January 1, 2019. However, this framework leaves states with a great deal of leeway and has raised a number of concerns. First, there is a worry that some states will delay implementation and may treat Basel III as a set recommendations rather than requirements. This is in fact how the US and some other countries approached Basel II. Second, the opposite approach could be as damaging. The worry is that overzealous regulators may apply the new rules too soon and too strictly. This can hurt the competitiveness of banks in these jurisdictions. Third, the speed and extend of implementation will depend on the nature of national regulatory and legal institutions. In some jurisdictions, such as the UK and France, there is just one national regulator. In others, such as Canada and the US, there are multiple regulators with different jurisdictions. The situation in Europe is further complicate by the existence of EU regulators. Finally, in the past, the banking industry has opposed financial regulation and has been able to find allies in both in legislatures and among regulators.
Thus, the uncertainty surrounding costs and the problems in implementation pose a real threat to the new standard. They raise the possibility that Basel III will not be adopted consistently across jurisdiction. There is also the danger of regularity arbitrage. This could allow banks to avoid regulation and push standards down. Both of these problems have been acknowledged by the G20. The leaders have even pledged in the Seoul communiqué to resist these pressures.
The future for SIFIs still uncertain
The second great issue surrounding Basel III is the question of how it will treat the so-called SIFIs. The risk posed by financial institutions that are too-big-to-fail is widely acknowledged. The problem is that Basel III has not yet made a clear statement on this issue. Thus, while the BCBS has said that it will set higher standards for SIFIs, it has not spelled out what those standards are.
There is even more uncertainty as to which SIFIs the stricter capital standards will apply to. The G20 has recognised two types of strategically important banks: global and national. As the names suggest, global SIFIs are significantly to the stability of the global financial system, while national SIFIs affect only the stability of their domestic banking industry. So far, the G20 has agreed to impose stricter standard on global SIFIs. However, this raises concerns about the treatment of national or regional SIFIs. Specifically, will they be regulated at the same standard as small banks? If so, what impact will this have on national and regional financial stability?
The ultimate responsibility for deciding the fate of SIFIs is divided between the Basel Committee and the Financial Stability Board (FSB). This of course raises concerns about institutional conflicts and buck-passing. However, so far the two organisations have been able to work together. In addition, there is considerable overall in terms of their membership, which should make cooperation easier. Currently, the FSB has decided on the following timetable for tackling this issue: by mid-2011 they will identify which SIFIs will face stricter capital and liquidity standards, and by the end of 2011 these standards will be defined.
The question remains whether Basel III will live up to the ambitious goal it has set. Ultimately, the responsibility for this lies with the G20. This will not be an easy task. However, there is room for cautious optimism. Over the last two year the G20 has been able to maintain cooperation despite disagreements among its members, a difficult economic recovery, and domestic political opposition. During this time it managed to make headway on some very difficult issue, such as avoiding protectionism, coordinating stimulus, and reforming the IMF and the multilateral development banks.
Does the memory of the crisis will fade?
The problems Basel III is tackling are very complex. Therefore, it is not enough to create a new set of standards. The real challenge is in implementing and ensuring that the new rules are enforced. It will also be necessary to monitor the effect of Basel III and adapt it when necessary. Policymakers will have to avoid overzealous implementation of the new rules at the expense of growth. But the greater temptation will be to weaken the rules once prosperity returns and the memory of the crisis fades. Thus, to be effective Basel III will have to remain a work in progress.
