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This Is the Absolute Worst Time to Weaken Global Bank Rules

Five decades of coordinated bank regulatory efforts to improve the safety and soundness of internationally active banks is under assault.

Anti-globalism sentiment in various parts of Europe and the U.S. has spilled over to international standard setting bodies such as the Basel Committee on Banking Supervision. While it is understandable that people around the world are questioning the benefits of global trade, reverting to a "my country first" mentality will end up hurting local economies, which will adversely affect banks.

The Basel Committee grew out of concerns about the bankruptcies of two banks, Herstatt Bank in Germany and Franklin National in the U.S. The failures of both institutions in 1974 forced regulators to see how interconnected international banks had become.

Before the committee finalized the Basel Accord — now known as Basel I — in 1988, national bank regulators around the world designed their own risk management, capital, liquidity, and leverage standards for the banks in their jurisdictions, with little, if any coordination. This enabled internationally active banks to create legal entities in countries where regulation and supervision was lighter.

Regulatory arbitrage can be very profitable for banks, since they can increase net income in countries with weaker capital requirements. Yet that also means a bank sustaining unexpected losses can be undercapitalized — leading to potential failure and disastrous consequences for both the bank's host and home countries. Basel was meant to combat such a result.

Nearly 30 years later, Basel III has become more complex as the Basel Committee membership has grown and internationally active banks have been allowed to become much larger and more complex. Earlier this year, the Basel Committee proposed guidelines to strengthen how banks measure credit risk, since it has become very clear that banks have significant flexibility — perhaps too much — in determining the risk of their loan and trading portfolios.

The reaction both from large U.S. banks, but especially from their European peers, has been fierce. As requirements become increasingly stringent, industry stakeholders often use the term Basel IV to describe the evolution. In mid-November, for example, the Danish Bankers Association and three Dutch banks stated that they are concerned "about the serious threat Basel IV represents to European banks and to these banks' ability to support European growth."

But tightening up how banks measure credit risk is very much part of the Basel III accord. There is no Basel IV. Basel was always meant to be an international accord of uniform capital standards, which is meant to evolve as markets and banks change. I would be terrified if we were still using the original Basel accord from the 1980s.

Bankers associations complaining about Basel's updated capital, liquidity and leverage standards rarely ever cite the incredible damage that weak or failed banks inflict on ordinary individuals.

It defies logic that precisely when European banks need more capital to sustain weaknesses in their loan and derivatives portfolios, European legislators are being very short-sighted in asking for lighter bank rules for banks. Because politicians' major goal is getting re-elected, they are not thinking of how important it is to teach banks to stand on their own feet. Legislators are not doing their constituents any favors by allowing banks to avoid measuring the full extent of their exposure to credit risks.

In addition to legislators, others like to claim that regulatory enforcement leads to less lending. A recent Wall Street Journal story, entitled "Bank Legal Costs Cited as Drag on Economic Growth," quoted remarks from Minouche Shafik, who said, "The roughly $275 billion in legal costs for global banks since 2008 translates into more than $5 trillion of reduced lending capacity to the real economy." Yet Shafik was clear about what led to those costs, attributing them to "the wave of misconduct which has emerged in the aftermath of the financial crisis." Of course, a portion of banks' costs are also likely due to the fact that they failed to invest in compliance personnel and technological systems for many years, and have had to ramp up quickly to compensate for those neglected expenditures to adhere to new regulations.

In a recent speech before the European Banking Authority, Claudio Borio, head of the Bank for International Settlements' monetary and economics department, argued that banks have been increasing their capital via "retained earnings and without much sign of an adverse short-term impact on bank lending." He added, "The ratio of bank lending to the private sector to GDP has been stable or has risen in many jurisdictions." In other words, banks can be well-capitalized and still lend.

If those opposed to Basel guidelines prevail, we risk returning to an uncoordinated bank supervision era rife with regulatory arbitrage. Having different regulations among host countries will increase work for on- and off-site bank supervisors. In the U.S., our bank regulators will need to be more vigilant of foreign bank organizations, because when rules are different, supervisors have to spend more time analyzing and deciphering exactly what types of rules banks are following. The Federal Reserve would have to allocate more resources to supervise and examine banks such as Deutsche and HSBC. In London, regulators would have to expend more resources to supervise and examine Citigroup and Mitsubishi.

In no country are legislators trying to provide more funding to regulators so that they have more human and technological resources to fulfill their responsibilities. Yet, if differing and possibly conflicting bank rules lead to supervisors missing any risks, which lead a bank to fail, Basel critics will trip over themselves to excoriate regulators, without ever raising a mirror to their own faces.

Mayra Rodríguez Valladares is managing principal of MRV Associates.

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Comments (2)
Ms. Valladares always provides thought provoking articles, and I mean that positively, even though I may not agree with her on everything. In this case, there are two premises offered with which I don't agree.

One is the statement that, "...people around the world are questioning the benefits of global trade, reverting to a "my country first" mentality." I believe this is a misinterpretation of peoples' concerns about globalism. They aren't questioning the benefits of global trade. They are worried about what globalis means to the sovereignty of their country. Globalism, at least in the minds of liberals in the country and abroad, necessarily includes open borders. Without controlled borders, there is no country. That's what the "my country first" mentality is about. People want to first preserve their country, have the power of self-government, and then be able to trade with other countries.

The second premise with which I disagree is that international regulation is an either or proposition. Either we go along with Basel III or we fall into uncoordinated regulation and financial armageddon. I think there is some middle ground here in which, perhaps, saner regulation can be developed.

Having said all that, I totally agree with her statement that banks need to stand on their own feet, as I take that to mean there should be no too big to fail concept.
Posted by Reg.Guy | Monday, December 05 2016 at 11:20AM ET
I agree with most of Ms. Valladares's comments but some other important points are missing that contribute to the backlash against Basel III and international standards. One is the lack of attention to the complexity of the new regulatory regime. Without regard to the merit of any particular regulation, the sheer volume of requirements can strangle the system. All regulators need to give more attention to the need to simplify. The other is a lack of sufficient attention to what a bank needs to be a viable business. The safest bank is one that does not exist. Safety is obviously critically important but there is a point where a bank can become so safe it cannot function and there is some doubt that both international and domestic regulators are giving that enough attention. Ultimately, regulators have to seek the right balance between safety and risk, but many appear to only be competing for who can impose the highest requirements.
Posted by gsutton | Saturday, December 03 2016 at 1:30PM ET
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