Viewpoint: Basel Committee Faces Tough Balancing Act

By Karen Shaw Petrou

That big banks are not without sin is undeniable. But the mortification proposed for them by the Basel Committee is so purgative that it throws into doubt the future of finance as we know it. Balancing needed correction with appropriate risk-taking is the act Basel must now pull off. It’s vital that the new capital and liquidity rules address known wrongs without wreaking wanton havoc.

That much is right with the new rules needs to be said — had aspects of them been in place before the debacle, its cost would have been less and many institutions would have been left standing. But, the sum total of the many parts of the massive consultative paper is so huge that we think of it as a monster-truck pile-up. The weight of all of the rules heading for global banking organizations will leave them little more than a smear on the financial system. This will exacerbate the trend toward “shadow” banks — still above and beyond Basel’s reach — a perverse result indeed as regulators reckon with the $8 trillion or so in shadow-bank assets in the U.S. alone.

We noted above that bankers aren’t without sin, but the cure for it in the Basel III rules is akin to self-flagellation. It goes too far and the rules are moving too fast. This isn’t to say that Basel I or even II should stay as is until all of this is straightened out. If Basel III collapses of its own weight, a dangerous vacuum will be left in which desperate banks could pile on risk unrecognized in the current rules in hopes of bolstering themselves for those to come. This would create an even more vicious procyclical spiral that will leave the global financial system still more vulnerable. Thus, the right next step is to take those aspects of Basel III that can be quickly implemented on a stand-alone basis and leave others for later, slower implementation if further research validates their utility as true risk buffers.

We’ll lump the new capital and liquidity rules into a general discussion of the new Basel framework because aspects of each part of the new Basel regime are right-on. One good proposal is the reliance on tangible capital instead of complex instruments called “intangibles” because no one for sure knows what they are worth. But doing this without reckoning with the role of reserves as capital worsens the potential adverse impact of a shift to tangible equity. Basel III should rewrite the rules on reserve recognition in Tier 1. Another good part of Basel III: it finally addresses the procyclical biases that lurk in the earlier Basel standards. This could be done better, but the rewrite is a darn sight better than before, with the new stress-test standards finally recognizing that business cycles last for more than a year or two.

The Basel Committee is also considering new global liquidity-risk rules. These parallel the valuable, improved stress-testing for credit risk.

As this quick discussion makes clear, there’s a lot that’s right about Basel III, but even the more straightforward parts of the proposal are anything but easy. A lot of it also isn’t all that good for banks, the financial system or the ongoing recovery. Under heavy pressure from heads of state, regulators could rush all of the rule to final action, doing a lot of unintended harm along the way.

What could Basel III look like on a reasonable turnaround for rapid implementation? It can and should better recognize reserves, begin to rely only on tangible capital, end rating-agency reliance and make stress tests count. None of this is hard; even the tangible-capital requirement can be put in place now globally if adjustments are made to the proposal and reserves are better reflected.

Another piece of the proposal that could soon be implemented is the leverage rule. We’ve long opposed this because of the perverse incentives created by a simple capital standard. For evidence, look at the U.S., a prime case as banks large and small bulked up on high-risk assets even as they remained “well capitalized” under the Basel I risk-based rules and the unique U.S. leverage standard designed to discipline this.

But we know now that complex capital standards can be arbitraged even if some of the proposals under way now make this harder. A leverage rule is thus a good way to ensure a robust capital base if — and only if — it’s well crafted.

To do this, the Basel III rules should, as proposed, count off-balance-sheet risk in the leverage requirement. They shouldn’t, however, treat all assets the same — if they do (also as proposed) global rules will mirror the U.S. ones and lead to the next bust, leverage not withstanding. A fix here is to reflect credit risk mitigation in the leverage standards. Any and all obligations with full-faith-and-credit backstops from sovereign governments (even Greece) should also be deducted from leverage now that they are better recognized in the risk-based rules.

Further, the “buffer” proposals in the capital rules should be deferred, if not dropped. These will add on to all of the more straightforward, needed capital rules to pound banks with capital standards none can reasonably be expected to meet anytime soon.

And finally, to the liquidity rules. As noted, much in them makes sense and could be done now. But the rules also include proposals for several liquidity-risk ratios. These are wholly untested. Putting them in place now will exacerbate capital pressures and put banks under still -more profit pressure at a time when funding is urgently needed for macroeconomic recovery. If miscrafted, the liquidity standards will be just like the U.S. leverage one: an incentive to perverse risk-taking.