Viewpoint: Basel III Rules Attempt to Do Too Much at Once

By Karen Shaw Petrou

A single set of new capital rules that tries to fix every problem identified in the crisis all at once for all time is as doomed as all the “perfect solutions” that went before. Basel III does a lot that’s good, but the combination of all of its charges creates a “synoptic” policy — that is, a one-off wholesale fix. Organization theory teaches us the hazards of synoptic solutions over incremental ones, but Basel apparently didn’t read the book.

On Sept. 12, the heads of global supervisory agencies — U.S. ones included — settled on the outlines of tough new rules that tell banks just how much shareholder equity they have to have to buffer taxpayers against risky loans, fancy trading and all their other on- and off-balance-sheet activities. That the new rules are tough isn’t the problem — tough is good as we’ve all learned at considerable expense. The problem with the new accord is that it’s jerry-rigged with untested add-ons and complex capital charges that will be phased in so gingerly that the entire Basel III accord’s impact is, at best, a guess.

Although there’s a Basel II agreement now, it was never implemented in earnest in the U.S. and was only barely in place elsewhere before the financial crisis unglued global banking in mid-2008. The seeds of the crisis lie in Basel I, a capital framework put in place in 1988 and left mostly as was until 2007 because global regulators spent years trying to craft a perfect new capital standard that satisfied bankers and regulators in every major market under any conceivable circumstance. By the time the grand scheme came out, bankers had perfected the art of capital arbitrage — taking risk not captured by capital requirements — and the trillion-plus-dollar debacle was predestined.

Basel III tries to fix the flaws in Basel I and II uncovered by the crisis, and that’s vital. But, as before, the Basel regulators are bewitched by the need for a single master capital plan. Basel II was a lowest common denominator designed to make everyone happy. Basel III is shaping up as a highest common denominator that will prove satisfying only to the purest of capital theoreticians — if the rules are in fact ever implemented. A transition period spread out to 2019 makes this, at best, a hope.

It’s not the basic Basel III framework that’s at fault. Much here fixes the flaws in Basel II — many of them well known at the start of the old capital regime. Rather, it’s all the new capital charges added atop the basic framework larded into an implementation “schedule” that puts Basel III in jeopardy as a meaningful discipline.

Basel III isn’t just a capital rule — common equity to risky assets — anymore. Now, it’s that plus a whole lot more. Included in the final accord are a conservation “buffer,” a countercyclical charge, a loss-absorbency capital requirement and — if that’s not enough — a surcharge for systemic institutions.

Each of these capital charges tries to fix a different problem. The conservation buffer is supposed to prevent bankers from being wastrels with shareholder equity by dividending it out or, worse, paying themselves too much when a bank starts to falter. The countercyclical charge is supposed to counteract boom-bust volatility. The loss-absorption one — a mouthful all by itself — is designed to put shareholder dollars ahead of taxpayers when big banks are rescued. Of course, now they are supposed to be liquidated, not rescued, making this charge essentially a penalty box for the biggest banks. At the same time, they are saddled with the aforementioned systemic surcharge to punish them for being so big that bailing them out might still be required in the face of all the reforms designed to prevent this.

Each of these capital charges is also complex, as is evident from the many footnotes to all of the academic papers on which each of the proposals is based. The countercyclical charge and the loss-absorption requirement are particularly fraught with footnotes. Many of the academic papers actually don’t support the proposals and others raise reasonable qualms about them — qualms often acknowledged by global regulators even as decision makers brush them aside.

In couture, a bit of trial and error is required. You do a pattern based on a best guess of the nicest fashion, cut fabric, then baste, pin and otherwise tack a dress together before sewing immutable seams and sending it out on the runway. Basel III should try the same approach — finish the best guess on tough, forward-looking capital rules and try them on for a while before adding so many accoutrements that the total shape of the rules is ever-changing and their real impact wholly unpredictable.

Karen Shaw Petrou is a managing partner at Federal Financial Analytics Inc.