In what seemed almost an after-thought in Basel’s most recent meeting statement, global regulators let it be known that they next year will look at reconstructing the daunting corpus of post-crisis regulation into an “integrated standard.” About time – in 2011, we spotted an array of problematic interactions among the capital and liquidity rules, expanding this cumulative analysis in 2012 to add resolution, derivatives, and what now seems like just a tiny sliver of what became the post-crisis rulebook. Is it too late now for Basel to make sense of its regulatory puzzle? Probably given the puzzle’s size and complexity along with the politics of subtracting even a piece. But, ever hopeful, I’ll return to a conclusion we drew after our 2012 cross-tabbed assessment of regulatory interactions: an integrated framework is possible with cost-benefit analytics putting each rule into the context not just of all the others, but also of market reality, economic inequality, and post-crisis monetary policy. Only this way can one determine if costly capital rules combined with stringent leverage standards in concert with resolution plans do more than reconfigure global finance into a shadowy system that still counts on too-big-to-fail companies, floats on thin liquidity cushions, exacerbates economic inequality and sets the stage for a new form of still more potent systemic risk.
Basel’s approach to regulatory analysis has much in common with that of U.S. regulators up to and including the most recent tailoring proposal. It starts with a “quantitative impact survey” (QIS) in which the gnomes of Basel first anticipate and then ask banks about how much each rule costs in simple dollar terms and how close companies are to compliance. As banks do what they must and comply, the rules are shown by these metrics to have worked. Voila – hit the number and a successful rule is implemented. That banks have ensured compliance by exiting core intermediation or infrastructure services, found new ways to arbitrage complex standards, or are taking on new risks is unexamined, avoiding inconvenient facts that account for unintended consequences and perverse interactions.
A classic example of blinders-on cost-benefit analysis is the quantitative assessment issued in concert with the Basel rewrite of the market-risk rules. Surveying all large-ish banks, Basel concluded that the FRTB was no big deal. As we noted in our assessment of the rule, the impact analysis would have been a whole lot more informative had Basel looked only at banks with significant trading books instead of coming up with weighted averages that obliterated actual impact.
What if Basel instead had looked not only at what the proposal would do to the trading banks at which it was aimed, but also at what trading banks would do in response? Going on, Basel should also have looked at how incentives in the rule altered bank strategy to ensure that efforts to fix a major problem in the first market-risk rule – regulatory arbitrage – were resolved in favor of tougher capital without new disincentives for risk-hedging and sound securitization. Simply shutting banks out of hedging of course raises their risk, not to mention that of all their counterparties even as hedge funds remember how they got their name and fill the breach. Securitization is a critical source of credit availability and market liquidity premised in part on trading. There’s a link here too, and not just between capital and credit, but also to liquidity given securitization’s role and how it’s treated – punitively – in liquidity regulation.
In essence, global and U.S. regulators have constructed a regulatory methodology – I can’t dignify this by calling it cost-benefit analysis – that decides what the right total should be – say a ten percent risk-based ratio or a 100 percent LCR – and then squeezes banks into the number to declare success on each regulatory measure regardless of interactions, side-effects, or emerging risks. To be fair, industry counter-arguments are often little better.
I can’t tell you how many comment letters I’ve read in which rules are attacked on grounds of compliance burden or competitive impact. A really valuable rule should be imposed no matter the compliance burden and competitive impact is a bank’s – not regulator’s – look-out. What matters is what each rule does in the broader context of all the others and the financial system as it evolves, not how a bank’s bottom line might fare when looked at solely through the prism of yet another Basel standard. Notably, when industry advocacy is policy-focused, substance-based, and analytically robust, it often works. Regulators want to do right even if their own methodology often leads them astray.
If Basel is to come up with a truly integrated global framework – and what a good thing that would be – then it needs to move beyond quantitative analyses that are little more than wish-fulfillment exercises. If the industry wants global and national standards that make business sense, then it will need to show how its incentives align with long-term financial stability, not a bit of extra money in the bonus pool. Maybe next year.