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IVORY TOWER: The Bank for International Settlements, home to the Basel Committee, whose risk-based capital ratios proved ill-suited to the real world.

One Cheer for Bank Regulators

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In recent weeks, bank regulators in the United States have taken significant actions to improve the safety of the financial system. While these are steps in the right direction, they are only baby steps, insufficient to prevent another crisis.

The U.S. authorities approved the latest capital and liquidity requirements developed by the international Basel Committee on Banking Supervision (known as Basel III). In doing so, they marginally improved upon the European version of Basel III.

Specifically, U.S. regulators approved higher minimum regulatory capital ratio values than required by Basel III, imposed higher capital requirements on large designated financial firms, and identified which nonbank financial firms would be subject to the higher capital ratios as well as to enhanced regulation and supervision.

Although U.S. banks have been subject to a simple equity-to-total-asset leverage ratio for many years in addition to risk-based capital ratios, Basel III extended the leverage ratio to all covered financial institutions in other participating countries for the first time. However, although the U.S. capital requirements were increased, they were not increased enough. The new requirements would not have been sufficient to absorb the large losses experienced by banks and other financial institutions in the financial crisis.

Moreover, the risk-based capital ratios developed in previous iterations of Basel were not deleted. Although intuitively pleasing because riskier activities are subject to higher capital ratios, these ratios proved ill-suited to the real world. It was hard for regulators to get the weights right, and the weights assigned were subject to political pressures. Witness the low risk weights assigned to long-term fixed rate mortgages, to mortgage-backed securities held off balance sheet in special purpose entities, and to sovereign debt held by European banks. To match the complexity of the real world required hundreds of pages of regulations, which made risk weights tempting for banks to game and effectively opaque and difficult for outsiders to monitor. Although imperfect, simple equity leverage ratios are cheaper to compute, harder to circumvent. They are more transparent, more understandable. They include only capital accounts subject to loss without question.

Also missing from Basel III are: sufficiently strong requirements that specify that prudential sanctions for poor performance be imposed promptly, something regulators have been notoriously poor at doing; and a trigger at slightly greater than zero book capital at which point the bank is closed, so that the game is up when the owners’ funds are effectively gone. If successful, only shareholders and not depositors or other creditors would suffer losses.

All told, the regulators have finally recognized the errors of their ways, which came at great cost to the economy, and begun to turn things around. But, they have a long way to go to make the financial system safer and to greatly reduce both the chances and the magnitude of future financial crises. At this point, they deserve some credit, but no more than one out of three cheers.

Robert Eisenbeis is the vice chairman and chief monetary economist at Cumberland Advisors. George G. Kaufman is the John Smith Professor of Banking at Loyola University Chicago. Both are members of the U.S. Shadow Financial Regulatory Committee.

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Comments (1)
You write "the risk-based capital ratios developed in previous iterations of Basel were not deleted"

In fact they are still the pillar of Basel III, and the recent consultative paper put out by the Basel Committee, does not even question their validity, and much less does it mention how these ex ante perceived risk based capital requirements, distorts the allocation of credit in the real economy.

http://subprimeregulations.blogspot.com/2013/08/members-of-basel-committee-for-banking.html
Posted by Per Kurowski | Wednesday, August 21 2013 at 8:10AM ET
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