All too often, grand schemes are brought low by the pesky complexity of the real, hard world. Even something as seemingly simple as a single garment has proved impossible. NASA has put millions into a super spacesuit for astronauts but, even with this, a single garment that does all for each has yet to be crafted. Spacemen must still put on underclothes, shoes and socks – admittedly a whole lot niftier than ours – before venturing into the cosmos. Bank regulators should take a lesson – a single set of new capital rules that tries to fix every problem identified in the crisis won’t fit. Worse, if bankers can’t figure out some of the buttons, there will be accidents.
Our complaint about the Basel III rules isn’t that they are too tough. We’ve actually been suggesting reforms to Basel I since it was released in 1988 – yes, that was a while ago – and argued for toughening up Basel II when the first of its consultative papers came out in 1999. From the start, for example, we’ve pointed to the unduly lenient treatment of off-balance sheet instruments, from which all sorts of systemic risk sadly ensued. To be sure, we haven’t much liked the leverage rule because it’s too close to the super-spacesuit – a single, simple rule that permits all sorts of arbitraging. Markets proved us sadly right here too, but now we’re reconciled to some sort of a leverage rule. It’s a reasonable control on the more complex risk-based standards, at least it will be if not dumbed down too much in the final regulations.
What we don’t think will work is the effort to make the new rules do all things for all banks all at once. This isn’t the problem in the straightforward (sort of) parts of the risk-based capital rules that rewrite Tier 1 and Tier 2 capital and how it is held against risk-weighted assets. The fatal flaw is all the stuff added to this basic garment in an effort to make a raiment satisfactory to even the most perfection-minded theoretician.
Look at what’s being basted on to Basel III capital. First, of course, it still includes the Basel II operational-risk charge – one we continue to think loaded with unintended consequences. But, ops-risk is old news, so let’s look at the new capital charges in Basel III: a conservation “buffer,” a counter-cyclical charge, a loss-absorbency capital requirement and – if that’s not enough – a surcharge for systemic institutions.
We won’t describe each of these capital requirements, as clients can find in-depth analytics on them via a chart on the FedFin website. What’s left out of those analyses – you don’t have to thank us – are all of the footnotes to all of the academic papers on which each of the proposals is based. The counter-cyclical 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 run-way. And, even then, shoes, the purse and maybe a nice hat are extra. 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.