Following President Barack Obama's re-election, I argued financial reform would not be a priority for his administration, given other challenges such as job creation, gun control, housing policy reform and immigration. Recently, however, some politicians have been fired up over the "too big to fail" debate. Last Friday, a draft bill from Sens. Sherrod Brown, D-Ohio, and David Vitter, R-La., that would require banks to have higher capital requirements was leaked to the media.
Banks should definitely be better capitalized. The 2008 financial crisis illustrated that interconnected, large banks were overleveraged and undercapitalized. U.S. banks have yet to become Basel II compliant. In the U.S., Basel III rules have not even been finalized, much less implemented. It makes no sense for Brown and Vitter to scrap Basel III when its numerous components could empower bank regulators to increase the amount and quality of capital banks hold, especially for large banks. Also, if there are components that are not sufficiently stringent, U.S. regulators can strengthen Basel III so that banks pose less of a global systemic risk.
Some legislators and bankers love to paint Basel as un-American. Nothing could be further from the truth. In 1973, the U.S. and U.K., later joined by Japan, were the first countries to start discussing the Basel Accord, finalized in 1988. The U.S. became involved, because regulators finally understood how interconnected banking systems had become after Herstatt Bank collapsed in the early 1970s. Scrapping Basel III would send a signal to other countries that trying to have uniform, international capital standards is no longer a U.S. goal. U.S. banks would endeavor to find countries where capital requirements are lighter; regulatory arbitrage would be worse than it already is. If the U.S. were to renege on its commitment to the Basel accords, European banks, given their current condition, would have a perfect excuse to demand lighter capital rules.
Politicians and pundits are focusing disproportionately on the concept of risk-weighted assets, which is part of Basel's Pillar I, where guidance exists for the measurement of credit. This concept arose practically even before the first Basel was formalized. In the original Basel Accord, the risk weights were too simplistic, not risk sensitive and traders would gravitate to buying riskier corporate debt because the risk weight for all corporate debt, irrespective of probability of default, was the same.
The RWA concept is not unique. Why do we all pay different life insurance premiums? Gender, health history, danger of occupation, amount of travel and age are all the risk metrics which go into actuarial models to determine mortality. The sooner we are likely to die and the larger the benefits we want to leave our beneficiaries, the more that policyholders pay. Analogously, the higher an issuers' probability of default and the higher the loss severity will and should influence how much banks allocate for the level of risk of a particular issuer or borrower. Pillar I gives guidance as to the internal rating models banks should use in order to get permission from their regulators to derive their risk-weighted assets.
Will banks have substantially different RWAs either because their models differ or because they can manipulate the credit risk drivers? Yes. This year, the Basel committee released a study showing that banks have very disparate risk weights for market risks due not only to differences in models, but also due to supervisory judgment.
