The Basel Committee on Banking Supervision is finalising the next generation of global banking rules - the Basel III Accords, often simply called "Basel III". Essentially, these rules aim to protect the world economy from the worst effects of future financial crises. And they aim to minimise the risk that governments will have to spend money protecting private banks and their creditors.
The new rules aim to avoid the failure of Basel II - imperfect and under-adopted rules now discredited by the 2008 global financial crisis. They take a more critical view of leverage in general, and of risk "insurance" and trading in debt between banks and other players. They ask the banks to hold a larger "buffer" of capital, and more liquid assets.
All these new rules reflect an deepening belief by global regulators that the banking system is prone to bouts of dangerous over-optimism - a view the Reserve Bank of Australia has held for at least two decades
Few believe Basel III alone will prevent future crises. As
Bank of England governor Mervyn King has put it: "it is no criticism of Basel III to say that it is not a 'silver bullet' ... In the area of financial stability, it makes sense to have both belt and braces."
An important question is whether the current global financial system can benefit from a strong set of rules for banks' capital and liquidity, or whether banks and other financiers outside the formal banking system will simply work around them. Global banking regulations, including Basel rules, tend to have unintended consequences.
Regardless of the effect of Basel III, the main burden for preventing imprudent bank behaviour will continue to fall on national prudential regulators such as the Australian Prudential Regulation Authority.
Timetable
The Committee confirmed the shape of the new rules at a meeting in September 2010, and the broad proposals were ratified at the G20 meeting in Seoul in November 2010.
The rules will come in slowly over several years. New capital ratios, for instance, will be phased in from 2013 to 2018.
Secrecy conditions imposed by the Basel Committee, the group drawing up global banking rules, have kept the evolution of the global rules obscure.
The rules in detail
Capital ratios
Basel ratio table
The Basel III rules will impose a series of ratios of capital to risk-weighted assets. The ratios were confirmed at a meeting of the committee on 13 September 2010. The ratios (see also the table) are currently as follows:
- Common equity, consisting of ordinary share capital and retained earnings, must be a minimum of 4.5 per cent.
- Total Tier 1 capital, including common equity and a few additional capital types, must be a minimum of 6.0 per cent, markedly higher than the Basel I ratio.
- Total capital, including both Tier 1 capital and various other reserves, provisions, and hybrid and subordinated debt, must be a minimum of 8.0 percent.
- An additional "conservation buffer" - an extra amount of common equity - can be as large as 2.5 per cent for an individual bank. Banks that do not meet this conservation buffer will be subject to restrictions such as limits on dividend payouts. In practice, banks are expected to treat the conservation buffer as mandatory.
- Total common equity, including the conservation buffer equity, must now be at least 7.0 per cent.
- A counter-cyclical capital buffer - a further 2.5 or 3 per cent of Tier 1 capital (amount unconfirmed), to be invoked at times of high credit growth. The precise conditions for triggering the buffer are still being negotiated. But the BIS aims to have it used only once every 20 years or so in a given national market.
The conservation buffer is designed to give banks an extra source of capital to draw on during "periods of stress". The more of the buffer that is used, the greater will be the restrictions on earnings distributions, such as dividends.
The counter-cyclical buffer of up to 2.5 per cent is designed to slow credit growth when it threatens to grow at what history suggests are dangerous rates. Just how it will be used is not yet certain, but there are suggestions it should be used no more than once every decade or two.
The new capital ratios will be phased in from 2013 to 2018. A series of deductions from allowable capital will also be phased in by January 2018. The conservation buffer will take effect by January 2019.
The Committee has proposed that all bank debt that counts towards regulatory capital - including hybrid instruments such as preference shares - would need a clause requiring it to be written off or converted to equity in case of a state rescue or a decision that the firm is about to become nonviable.
Some prominent economists, including the University of Chicago's Eugene Fama and John Cochrane, the London School of Economics' Charles Goodhart and Princeton's Markus Brunnermeier, wrote in an open letter in late 2010 that the capital ratios should be much tougher.
Leverage ratio
The leverage ratio is a ratio of gross loans and investments to capital. It would effectively cap the simple leverage of banks at 33 times Tier 1 capital. It iss intended as a simple supplement to more sophisticated rules.
It is reportedly designed largely to guard against a repeat of Swiss giant UBS's near-fatal mid-2000s overgearing. It would have blocked some of the specific borrowings which got UBS into trouble.
The leverage ratio will have a long transition period. "Supervisory monitoring" will start in January 2011 to track the underlying components of the agreed definition and the resulting ratio. The actual leverage ratio will start to be tracked in January 2013. Bank level disclosure of the leverage ratio and its components will only start in January 2015, and compliance will commence from the start of 2018.
Liquidity coverage ratio
This new regulatory ratio aims to ensure banks can continue to provide funds during a market dislocation such as those of late 2008. Banks will be required to hold sufficient high-quality liquid assets to cover expected net cash outflows for thirty days. High-quality liquid assets are, essentially, government bonds and covered bonds.
The ratio is defined as: (stock of high quality liquid assets) / (net cash outflows over a 30 day time period in an extreme stress scenario), with a minimum of 100 per cent.
Australia and a few other nations, such as Singapore and Saudi Arabia, have faced a problem with the proposed minimum liquidity standards because their government debt is low and expected to fall further.
The problem has been solved for Australia by allowing Australia's top 40 authorised deposit-taking institutions to set up a secured lending facility with the RBA. It will be possible to secure this facility with any assets currently listed by the RBA as eligible for repurchase transactions. This list includes not just government and semi-government securities, but bank bills, asset-backed commercial paper and residential mortgage-backed securities. This provision has been described in some reports as an "exemption", but is better seen as a way to deal with an anomaly in the rules.
Stable net funding ratio
This new regulatory ratio aims to encourage banks to rely more on more medium and long-term funding.
The ratio is defined as: (available amount of stable funding) / (required amount of stable funding), with a minimum of 100 per cent.
Counterparty trading limits
Under Basel II, banks could reduce the regulatory risk weighting of a risk-weighted asset by hedging against it using credit derivatives. A bank could thus own a BBB security with a 100 per cent risk weighting, but could hedge the investment with a counterparty to have it treated for regulatory purposes as a AAA-rated security with a 20 per cent risk weighting.
As an example, one popular counterparty for both US and European institutions was insurance giant AIG. (Goldman Sachs was reportedly AIG's largest trading partner.) When AIG could not pay out on the insurance it had written, the banks and other institutions who had written contracts with AIG were left exposed in ways they had not expected. This exposure occured even when the assets underlying their loans had not yet gone bad; in many cases, they had to revalue assets downwards.
This counterparty risk, though little mentioned in finance textbooks, was at the heart of the global financial crisis.
Basel III raises the Basel II requirements for risk-weighted assets to support counterparty credit risk, and introduces a new capital charge designed to reflect counterparty risk. There will now be different capital requirements for exchange-traded derivatives, which carry low counterparty risk, and riskier over-the-counter derivatives.
The economic cost of Basel III
Holding capital, maintaining liquidity and restricting dealings with counterparties all comes at a cost. (Steve Waldman notes that the opposite of "liquidity" is "commitment".)
Estimates of the economic cost of these measures vary widely. In June 2010, bank lobby group the Institute of International Finance predicted Basel III and other measures would cost the US, the euro zone and Japan 3.1 percent of economic growth and nearly 10 million jobs over five years. The reforms would force banks to raise $US700 billion of new tier-one capital and issue $US5.4 trillion of long-term wholesale debt by 2015, it said. The IIF's estimate of economic impact looks alarmist. Studies by the Financial Stability Board and the Basel Committee released in August 2010 argued that if the rules were phased in over four years, then for every 1 per cent rise in capital ratios, growth would fall by only 0.2 per cent over the four-year period. And they said an increase of 25 per cent in liquid assets held by banks would have less than half of the effect of a 1 per cent rise in capital ratios over the same period.
The Reserve Bank governor, Glenn Stevens, noted in a speech in July 2010 that the experience of the last decade suggests surging credit and leverage doesn't do that much for growth, implying that restraining it slightly more may have a low cost. And if regulation stabilises the global financial system, he added, it is worth some cost. But we need to ensure the benefits outweigh the costs, including "unintended consequences" such as slower economic growth.
Weaknesses of Basel III
Basel III retains several flaws of the previous Basel II rules. In particular:
- Basel III relies heavily on an underlying mechanism - capital ratios - which spectacularly failed to prevent the global financial crisis. The crisis occurred even though most banks' capital ratios appeared strong. (Lehman Brothers reported 11 per cent Tier 1 capital just days before its collapse.) Banks responded to higher capital costs by pushing business of their balance sheets and into the "shadow banking system" where capital rules did not apply.
Bank of England governor Mervyn King: "When sentiment changes only very high levels of capital would be sufficient to enable banks to obtain funding on anything like normal spreads to policy rates, as we can see at present … That is what happened in 2007-08. Only very much higher levels of capital - levels that would be seen by the industry as wildly excessive most of the time - would prevent such a crisis."
Economist Raghuram Rajan in the Financial Times: "The minimum hurdle that reforms should meet is whether they would have prevented the last crisis. Any feasible level of required capital would not cross this hurdle, so let us not rely too much on it to avert the next crisis."
- Basel III continues to rely too much on credit ratings. The IMF, among others, has argued in recent papers that "markets need to end their addiction to credit ratings" and remove "the mechanistic use of ratings in rules and regulations". Instead ratings should be used as one of several tools to manage risk.
- Banks remain trusted to use their own internal models to measure risk, using models such as value-at-risk which have been shown to have substantial flaws in many situations.
- Risk weightings still allow banks to create very high effective leverage. Under Basel III, banks need to hold equity against their risk-weighted assets. This provides an incentive to find low-risk-weight assets which can then be leveraged. One attractive asset will be sovereign debt; AA-rated sovereign debt will still carry a zero risk weighting. Housing will continue to require less capital than business lending. Lending to most businesses, in contrast, will require capital of about 8 per cent.
The essence of the global financial crisis was risky assets - mostly US sub-prime mortgages - that had been carelessly assessed by the market and classified incorrectly as risk-free, then dispersed to all corners of the financial system. The risky assets were precisely those which were regarded as "safe" under Basel II - but which in fact were not. That is, the risky assets had low "official" risk but high real risk. (The risks were also correlated: many of them had a good chance of going bad at the same time, magnifying their likely economic impact.) Basel II gave market players enormous incentives to seek out such assets - in effect, to find the best regulatory arbitrage.
In a crisis where a large number of assets fall substantially in value, it matters little whether a bank's capital is 5, 10 or 15 per cent. It will still be overwhelmed.
To add to the problem, there is no asset so safe that it cannot be made unsafe by overbidding and overgearing.
Nothing in Basel III prevents that problem from recurring.
Beyond the issue of banks' safety is another issue which Basel III cannot address. The financial system inevitably breaks down if creditors are willing to lend to foolish investors. The bail-outs of creditors during the global financial crisis may have raised expectations that creditors will be rescued from future poor decisions.
The most severe critics of the system believe Basel III does little to address underlying problems with the global financial system. Adrian Blundell-Wignall, the former RBA economist who is now Deputy Director of Financial and Enterprise Affairs at the OECD, has gone further than most: his personal view is that the Basel II system proved so flawed that such frameworks might not be worth using.
How effective will the new rules be?
These are easily the toughest global banking rules yet agreed. But there is no guarantee they will save the banks from their next episode of over-optimism. The 2008 crisis showed that when the web of global lending unravels, even well-capitalised institutions are at risk.
Strong and sophisticated regulators will continue to be needed. And they will continue to have to make tough calls about the risks taken by individual institutions and overall risks within the financial system.