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Basel III Critique Emerging

Columbia University professor Charles Calomiris offers up his own slate of regulatory reform measures.

Although it could take years to gauge the full impact of the latest wave of new bank capital requirements, there have been plenty of snap judgments. Investors in financial stocks reacted favorably when the so-called Basel III guidelines were released in mid-September.

But even in the face of a comprehensive study by global regulators indicating that a better-capitalized banking sector would yield long-term, positive economic benefits, some bankers have, predictably, griped about the rules’ potential credit-tightening effects. Deutsche Bank chief executive Josef Ackermann has been particularly outspoken, warning in a Frankfurt conference speech on September 23 that a “race to the top” to exceed the Basel standards would have unintended negative consequences.

[Parsing Basel III Bank Rules: Discussing the new Basel III banking rules with Rodge Cohen, senior chairman of Sullivan & Cromwell. Airtime: Thurs. Sept. 23 2010 | 12:11 PM ET]

Now a respected observer and critic of financial regulation is asserting that Basel III “cuts the wrong way” and requires a closer look — which he optimistically believes it will get. “A consensus is forming” to bring fresh thinking to capital and other regulatory rules “and deal with these problems head-on,” said Charles Calomiris, the Henry Kaufman professor of financial institutions at Columbia Business School, on September 23 at the Blouin Creative Leadership Summit, an annual event sponsored by the Louise Blouin Foundation of New York.

Calomiris, also a professor at Columbia’s School of International and Public Affairs and a member of think tank panels such as the Shadow Financial Regulatory Committee and the Pew Charitable Trusts’ Financial Reform Project, said policy responses to the financial crisis miss the fundamental point that risks were taken in excess of the capital available to support that risk, and that incentive structures to align risk with budgeted capital were lacking.

Citing research by Vijay Yerramilli, an assistant finance professor at the University of Houston’s Bauer College of Business, Calomiris said that a well-compensated chief risk officer and a strong risk management function are essential attributes of successful bank holding company performance. Calomiris said that blaming “bad luck” or “black swans” diverts attention from the improper metrics and misaligned incentives that brought on the crash. He reeled off the names of financial firms that “did okay” — including Credit Suisse, Deutsche Bank, Goldman Sachs and Morgan Stanley — contrasting them with the likes of Bear Stearns, Citigroup, Merrill Lynch and UBS, which lacked the appropriate controls.

Calomiris, who said he has not yet detailed his thoughts in a formal paper, considered it “preposterous” that the Basel III tier-1 equity capital standards “were satisfied perfectly by Citigroup.” If these rules had been in place, they “would not have stopped what we experienced.”

He offered five ideas in the spirit of “getting the mechanics right, [with] forward-looking risk measurement and robust metrics for better risk management.” They are: (1) budget capital according to interest rates on loans, a formula that would have required significantly higher reserves and presumably a disincentive on subprime lending; (2) reform the credit rating agencies, including reliance on numerical default probabilities rather than letter grades; (3) rely on contingent capital certificates for converting debt into equity when necessary to shore up a weak institution; (4) implement an explicit “living will” system for resolving failed institutions; and (5) expose creditors to “haircut” losses, removing protections written into the Dodd-Frank Act.

Calomiris believes that such measures would close regulatory reform gaps “if we have the political will” to go beyond measures already taken and address the remaining flaws.

The Columbia professor and three co-panelists — Joseph Wambia, CEO of Africa-focused investment firm Wambia Capital Group; quantitative finance expert and educator Paul Wilmott; and Josh Wolfe, co-founder and managing partner of Lux Capital — were asked to list some of their risk concerns for the next few years. Defaults by sovereign, state and municipal borrowers were a common response. Without being specific about actual events, Wilmott suggested watching for consequences stemming from developments in China, high-frequency trading and cyberterrorism.

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