To understand Basel III and the unfolding regulatory environment, it is important to see the new requirements as the regulators' response to their own surprise at the near collapse of the global banking system. They understood the need for stronger safeguards to prevent the world's economic security from being similarly jeopardized again. And while in that context the new requirements-both international and national-make sense theoretically, it as not clear how the pulls of capital and liquidity will affect the long-term health of the banking industry, and the economy as a whole. The push for increased capital and liquidity and decreased risk might lead to reduced credit availability. In trying to prevent a repeat of the Great Recession, Basel III could well be applying the brakes on the entire financial engine.
For the top 30 or so U.S. and European banks, these capital and liquidity requirements will be a non-event. Also the Canadian and Australian institutions are in good shape given their strong regulatory systems and tight risk controls. However, for the smaller and midsize banks, the increased competition for capital and liquidity may produce very strong pressure for consolidation both in the United States and Europe.
One might argue that the consequences of a global economic meltdown far outweigh what impact the increased requirements might have. And indeed the tradeoff would be worthwhile if Basel III were the only way to keep the banks safe. But it may not even be the best way. Basel III is a reactive, one-size-fits-all approach that favors the large banks and if applied by itself is ill-suited to a dynamic financial system that can innovate faster than regulators can respond. Rather than helping bankers navigate this landscape, these international standards, along with the national ones, merely serve to escalate regulatory and compliance costs that are already out of control.
So what is needed in addition to punitive regulation?
First, the stress tests that were administered in the United States, and to a lesser extent Europe, can provide an early warning system that enables continuous monitoring on the structure of the financial institution. To be effective, these need to be frequent-say, quarterly-and easy to execute. Most importantly, the results should be transparent.
Testing should include credit, market and operational risk components. There should be greater focus on the microeconomic impacts brought on by changes in industry subsegments that would reveal an imbalance of exposure.
Second, governance for risk management needs urgent attention from banks and regulators on both the tactical and strategic levels. It's clear the senior ranks were largely unaware of the precise exposures of complex products, and a comprehensive compliance and risk management framework was absent. This would best be addressed by a cross-product risk ombudsman who brings segmented and fractured approaches back together. The ombudsman's responsibility would lie in uniting existing approaches, compensating for data issues and manually stitching together information buried in legacy systems that don't speak with each other.
Finally, executives need to accept responsibility for the bank's health. They need to be more knowledgeable of the new risk management environment, and there should be structures in place that would manage not just for short-term performance but bring long-term viability.