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U.S. in the Background in Basel Regulatory Debate

The Basel III capital bank standards are the center of some heated debate. Surprisingly, that debate is being led from overseas, as the U.S. grapples with the Dodd-Frank Act and the mid-term elections. Mervyn King, governor of the Bank of England, criticizes Basel during the Buttonwood Gathering.

While U.S. financial policy makers are up to their ears in the Dodd-Frank Act rule-writing process, and with the political class preoccupied with the anticipated power shift in the midterm elections, critical voices from overseas have taken control of the continuing – now largely retrospective – debate over regulatory reform.

The criticisms take aim at the recently adopted Basel III bank capital standards, and coming as they do from the likes of Mervyn King, governor of the Bank of England, they are very different from the complaints of prominent bankers who have contended that higher capital requirements will constrain lending and forestall economic growth.

International regulators, led by the Basel Committee on Banking Supervision, have done their best to refute such arguments, while giving the industry until the beginning of 2019 to adjust fully to the new rules. “The new standards will reduce the likelihood and severity of future financial crises and create a less procyclical banking system that is better able to support long-term economic growth,” the Basel-affiliated Financial Stability Board asserted in a statement on Oct. 20, following a meeting held to prepare for the November G-20 summit meeting in Seoul, Korea.

Five days later, in a lecture at the Buttonwood Gathering in New York, King lowered the boom on Basel III, while also finding weaknesses in such other pillars of post-crisis reforms as the U.K.’s bank tax levy and efforts to come to grips with the too-big-to-fail problem. He suggested that more “radical” capital measures or some kind of “functional separation” of institution types, a la the Volcker rule considered in the U.S., might have to be pursued.

King allowed that Basel III is “certainly a step in the right direction” and an improvement over the two earlier iterations, but he concluded that “Basel III on its own will not prevent another crisis.” The rule “fails to recognize that 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,” he said.

The 2008 crisis produced the conundrum that “banks that were perceived as well-capitalized can seem undercapitalized, with concerns over their solvency. . . . 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.”

Risk Weighting

King pointed out that the Basel-mandated risk weights for calculation of required capital “are computed from past experience. Yet the circumstances in which capital needs to be available to avoid potential losses are precisely those when earlier judgments about the risk of different assets and their correlation are shown to be wrong.” It therefore could be said that “a financial crisis occurs when the Basel risk weights turn out to be poor estimates of underlying risk . . . because the relevant risks are often impossible to assess in terms of fixed probabilities.”

The Bank of England for that reason advocated a simple leverage ratio as a more robust approach to backstop capital requirements, said King.

He also criticized the Basel framework’s emphasis on the asset side of bank balance sheets. Because Basel II “excluded consideration of the liquidity and liability structure of the balance sheet,” when the U.K. adopted that standard in 2007, the highest capital ratio paradoxically belonged to the ill-fated Northern Rock. “Whether the measures included in Basel III will be able to deal properly with the risks that result from inadequate levels of liquid assets and a risky structure of liabilities remains to be seen,” said King.

All of that notwithstanding, King said the Bank of England will not accelerate the Basel III timetable for U.K. banks. The system cannot be transformed overnight, and it will take years to obtain the desired results of “radical reforms.”

Others taking Basel III – or re-regulatory trends in general – to task in recent days included London School of Economics emeritus professor and former Bank of England Monetary Policy Committee member Charles Goodhart and Jacques de Larosière, a former head of the International Monetary Fund who has overseen influential studies on global financial reforms and is currently co-chairman of the financial services think tank Eurofi.

Goodhart, in Amsterdam to speak at Sibos, the annual convention of the Swift international bank technology cooperative, said the Basel measures should have been focused less on individual bank sanctions and more on the systemic level, according to a Dow Jones report.

De Larosière, writing in the October 25 Financial Times, stated that the new capital and liquidity standards are misdirected, as “stable institutions, required to increase their return on investment, would reduce activities with modest margins such as lending to small and medium-sized enterprises. Alternatively, credit costs would rise, or banks would concentrate on the more profitable (and riskier) parts of their portfolios.”

De Larosière’s position was close to that of Citigroup chief executive officer Vikram Pandit, who, at the Buttonwood Gathering, clashed with Mervyn King by asserting that the regulations had gone too far and would discourage banks from serving market segments other than the most profitable.

Jeffrey Kutler is editor in chief of Risk Professional magazine, published by the Global Association of Risk Professionals.

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