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Will Basel III Dull or Sharpen Economic Cycles?

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A vote Thursday by the Federal Reserve on its version of the Basel III capital and liquidity standards should not be expected to generate much surprise and should confirm the inevitable for the banking industry: Strong headwinds for profitability lie ahead but also greater overall stability.  

A report by McKinsey in 2011, for example, expected bank returns to fall by more than 3% under the new Basel III regulations or about one quarter of what their returns are currently. While full implementation of the standards is years away, the study estimated that banks would need to raise an additional $500 billion in capital to comply with the requirements. 

While those numbers are sobering, McKinsey's prediction that banks would need to fill a nearly $800 billion shortfall in liquidity due to a pair of new liquidity ratios in Basel III is more startling.  If even close to being accurate, these two estimates, coupled with changes in risk weightings, new capital definitions and other calculations portend significant restructuring of bank balance sheets over the next several years.  This we have expected since the Bank for International Settlements first rolled out the components of Basel III.

The introduction of short-term (30-day) and near-term (one-year) liquidity ratios was a direct response to the severe liquidity disruption observed during the financial crisis.  Some empirical evidence suggests that bank liquidity exhibits procyclical behavior, ramping up sharply during a boom, and then plummeting during a bust.  If so, establishing a minimum level of liquidity over a specified time horizon may be prudent. But it is not clear what the time horizon should be, as liquidity stress can manifest over longer periods than a year. If the Liquidity Coverage Ratio and Net Stable Funding Ratio remain largely intact after the Fed's vote, the standards could constrain future lending activity.

Beyond the new liquidity ratios, a couple of new capital requirements also bear closer attention.  One of these is the new so-called "SIFI surcharge."   This new capital requirement would scale between 1% and 2.5% and be reflective of the underlying systemic contribution of the largest, most complex banking institutions.  The Basel Committee has established a set of indicators and weights that would be used in assigning the capital charges. While the assessment criteria include such factors as complexity and interconnectedness, size and cross-border operations of Sifis, among others, the application of defined weights for each category seems a bit over-engineered. Rather, it may be worthwhile for the architects of the Sifi surcharge to look at some well known systemic risk measures in the academic literature that estimate the contribution to systemic risk by individual banks such as systemic expected shortfall or marginal expected shortfall. 

Another standard bearing close watching is the countercyclical capital buffer, designed to raise capital by as much as an additional 2.5% in times of financial stress.  Implementation of this new capital requirement is envisioned to link the relationship of credit in the financial system to a country's level of economic growth.  In theory, periods where credit demand has risen sharply relative to GDP may be associated with financial stress later on, implying that higher capital levels in advance of such outcomes may be warranted.  So far, it is not clear whether any conditioning variables used to determine such a countercyclical capital buffer could be sufficiently accurate to support implementation of this capital requirement.  In other words, more work needs to be done before the countercyclical capital buffer should be rolled out.

The Fed's vote is likely to be anticlimactic since hints so far suggest that it will largely adopt most of the Basel III framework.  While the intention to strengthen capital and liquidity buffers for the banking system is appropriate, the implementation of such metrics and their combined effects on the economy at large bear close scrutiny and further analysis.  In fact, one concern that seems to go unnoticed is the cumulative effect of regulation on amplifying procyclical outcomes to the detriment of consumers, investors and ultimately taxpayers. 

The regulatory response to the financial crisis has been the equivalent of the "Shock and Awe" campaign. Carpet-bombing the industry isn't the response needed at a time of economic fragility.  The answer is not more regulation, but the right mix of regulation to align incentives, reduce excessive risk-taking and mitigate market imbalances.

Clifford Rossi is an executive-in-residence and Tyser Teaching Fellow at the University of Maryland's Robert H. Smith School of Business. He has held senior risk management and credit positions at Citigroup, Washington Mutual, Countrywide, Freddie Mac and Fannie Mae.

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