Hoenig and Haldane Are Right About Basel III

The U. S. banking system is unique  because, unlike anywhere else in the world, its more than 6,500 community banks – or 90% of all its banks – establish a special local, "bottom up" character within the industry.

However, these community banks (defined here as financial institutions smaller than $1 billion in assets, which is  less than one-tenth of 1% the size of megabank JPMorgan Chase) and the distinct feel they provide are currently being threatened by excessively complex Basel III capital requirements.

If America's community banks were the umpire and the international Basel Committee on Banking Supervision were at bat for the Complexity team, the result of Basel III would be Strike Three—"and yer out!"

In opposing Basel III's costly complexity and dubious usefulness, the smaller banks have been joined by two prominent banking thinkers: Andrew Haldane of the Bank of England and Thomas Hoenig of the Federal Deposit Insurance Corp.

In what the Wall Street Journal called the "speech of the year," Haldane pointed out that "no regulator had the foresight to predict the financial crisis, although some have since exhibited supernatural powers of hindsight." He continued, "So what is the secret of the watchdogs' failure? The answer … is complexity." Indeed, the complicated Basel "risk-based" capital standards failed to slow down, and perhaps accelerated, numerous housing bubbles, including the U.S.'s.  They also helped inflate the European sovereign debt bubble, now causing so much anguish. "Complexity generates uncertainty," Haldane correctly stated.

Haldane argues that simple rules would have performed better than the complex ones did, but, as he relates, the response of the Basel Committee to the previous failure was to make things even more complex: "The documents making up Basel III added up to 616 pages," and "a large bank might need to estimate several thousand … parameters."

If this overly complicated approach is inappropriate for big, complicated banks, it is ridiculous for smaller, relatively simple ones. Not only will Basel III needlessly burden existing community banks, it will impede the healthy process of forming new ones. As it is, zero new banks have been formed in the U.S. since the beginning of 2011.

Hoenig, in his recent speech, "Back to Basics: A Better Alternative to Basel Capital Rules," argues the Basel approach is "a system fundamentally flawed."It uses "highly arcane formulas, suggesting more insight and accuracy than can possibly be achieved."This insight recalls the dictum of the great economist Friedrich Hayek: "I prefer true but imperfect knowledge … to a pretense of exact knowledge."

"Applying an international standard to community banks is illogical," Hoenig argues. In addition, we must add, the complicated and expensive practicalities of operating Basel III for smaller banks have clearly not been thought out. Hoenig concludes that it would be better "to acknowledge our limits, to simplify the system"and "reject the Basel approach."

If rejecting Basel III altogether in this fashion is not considered politically feasible, a sensible alternative would be to simply exempt all community banks from its requirements. This should be easy for the regulators to adopt as a policy because the credit union industry already is not covered by the proposed Basel III regulation — that is, effectively, it is exempt. Credit unions, besides being in the same business as banks, have the same structure of mostly small, local organizations. But that industry is not small in the aggregate: Its assets exceed $1 trillion.