For decades Congress has required U.S. regulators to establish minimum capital requirements to ensure that the nation's banking institutions operate in a safe and sound manner. Though the current capital rules could benefit from fine-tuning, they are simple enough to be understood by all interested parties and have a decades-long track record of not creating or exacerbating any domestic crises.
The proposed Basel II regime would introduce sweeping changes to the current regulatory framework. For the first time the nation's largest banking institutions would be able to determine their own capital requirements from models the banks create and manage. While these self-directed capital models would be subject to regulatory review, the potential for manipulation and the impracticalities of effective regulation and market oversight make such a regime incompatible with promoting safety and soundness.
Before experimenting with an unprecedented and untested approach to capital regulation, we need to remember that what is at stake here is the very stability of banking institutions that are critical to national and international financial systems. Given the interdependence of financial markets and the speed with which down-spirals can occur, the consequences of even a small mistake could be devastating. By the time the mistake is recognized, it may well be too late, and the only questions will be the size of the taxpayer bailout and the impact on worldwide financial stability.
Black Box Models
Proponents argue that Basel II would produce capital levels that are more closely aligned with economic risk and are justified by "modern risk management techniques." The mere fact that new, complex quantitative techniques exist does not justify replacing a simple capital framework with a complex capital regulation. Complex rules and models often invite mischief (see Enron, Barclays, Long-Term Capital Management, and Freddie Mac).
The sophistication of a risk-based model is no guarantee of greater accuracy, since every model ultimately depends on human inputs, assumptions, and interpretations. In fact, the probability of human error likely increases with the sophistication of the model. Models will always be wrong more often than they will be right, and especially so when the modelers have desired outcomes.
Only a handful of technically skilled employees at any bank will understand the most complicated elements of a bank's initial risk-based model. These technicians will likely miss subtle distinctions and developments that could dramatically impact real-world risk at the bank. Over time, and especially with personnel turnover, there will be continual loss of institutional memory about the tradeoffs and idiosyncrasies built into a bank's model.
Nonetheless, the bank will increasingly rely on the false certainty of the model and expertise and judgment of the technicians because the black box will be incomprehensible to most if not all of the bank's management and directors. It is more than a little ironic that, in this period of heightened concern about corporate governance and effective oversight, few board members or senior executives will have more than a surface understanding of the intricacies of Basel II or the bank's own model.
The Race to The Bottom
At the same time, management at Basel II banks will want to recoup their sizable investment in the expensive models and improve their competitive position, which will create results-oriented pressures for the black boxes to produce lower capital charges. Basel II banks will expect their capital requirements to decline, and will have the means to do so. Twist a lever here, push a button there, and the black boxes will magically spit out the desired capital level.
Basel II's do-it-yourself capital measurements will result in a race toward the lowest amount of capital reserves, thereby distorting the purpose of a capital regime. Since most Basel II banks will be "too big to fail," the government will be expected to bail them out if their capital reduction programs spin out of control (the classic "moral hazard" problem).
The financial and reputational incentives within the banks will encourage this greater risk-taking and gaming. Executive compensation is usually based on short-term performance against various financial metrics, including return on equity. Since capital is the denominator in the calculation of ROE, a bank that can reduce its capital will require less profitability to achieve a target ROE.
Executives will be incented to manage for the big score, and there will be immense pressures, both explicit and not-so-explicit, for the model's technicians to make incremental "improvements" to the black box, for officers to pursue aggressive strategies to reduce capital (such as through use of securitizations and derivatives), and for employees in the field to report information in a way that yields a positive result in the model. Many recent crises have resulted from individuals incented or pushed to pursue near-term results, irrespective of the risks or longer-term consequences.
The lower capital levels that Basel II banks obtain will also threaten the viability of those banks that remain subject to Basel I's higher capital thresholds, because the Basel I banks will either become attractive takeover targets or they will find it more difficult to compete for quality assets, leaving them with riskier assets, lower credit ratings, and higher costs of funding.
Regulatory Challenges
By focusing on fancy credit risk models, Basel II gives short shrift to improving supervisory standards and is overly optimistic about the resources regulators will have to supervise the new and complex capital rules. As Standard & Poor's pointed out in an Aug. 22, 2003, publication, "national bank regulators could be overwhelmed by the implementation of Basel II, with its intensive need for verification of the internal systems and databases of individual banks." Many of the front-line U.S. regulators have themselves expressed similar concerns.
And, of course, if U.S. regulators will have difficulty adequately supervising a Basel II regime, notwithstanding their larger staffs, what will be the situation overseas? Most bank systems abroad lack the strong regulatory features that we have in the United States, such as a leverage ratio requirement and active and informed regulators backed by the protections of prompt corrective action. While U.S. regulators place full-time on-site examiners at our largest banks, many comparably sized banks abroad are examined only sporadically and without anywhere near the same thoroughness.
It is certainly not appropriate or necessary for the United States to weaken its regulatory framework in response to Basel II, especially since U.S. banks and the U.S. banking system have proven much stronger and more resilient than their foreign counterparts during recent economic cycles. Instead of sinking to the lowest capital denominator, we should maintain our high national standards and insist that international bank systems improve theirs.
A Better Alternative
Many have taken on faith that an overhaul of the current one-size-fits-all Basel I accord is necessary to reduce so-called capital arbitrage, a concern that is overblown. Any safety-and-soundness risks to the banking system from these practices would be dwarfed by the risks resulting from capital-reduction efforts under Basel II.
The one-size-fits-all approach of Basel I may need some fine-tuning, but its simplicity allows it to be understood by boards of directors and management, applied consistently across institutions, and monitored effectively by regulators and market participants. Simplicity promotes stability. If additional risk categories are needed to more closely align capital requirements with risk levels, this can be done without resorting to Basel II's self-directed models.
The risk-weighting of these categories could also be modernized to better match current knowledge about actual risk exposures. Given the importance of capital rules and the consequences if mistakes are made, evolutionary changes are infinitely wiser than a revolutionary approach that would allow banks to determine their own capital requirements.
The Leverage Ratio
Regardless of the risk-based capital accord that is in place, the U.S. leverage ratio requirements described under existing prompt-corrective-action legislation and implementing regulations must remain intact. This is especially important in light of the FDIC's recent paper noting that risk-based capital requirements under Basel II's A-IRB would be far below the 5% leverage standard to be classified as "well capitalized." The FDIC in fact believes these Basel II capital requirements would often fall into a range currently deemed "undercapitalized."
Among other things, a minimum leverage ratio ensures that regardless of the risk-based model used by a bank there is at least a base level of protection in the event of a crisis, rather than relying primarily on an insurance fund or taxpayer bailout. It would serve as a counterbalance to unexpected risks that might arise or the manipulation created by either Basel I or Basel II.
Moreover, there should be legislation or other types of binding provisions that would prohibit the U.S. leverage ratio from being reduced or waived without some high-level review and action, possibly an act of Congress or the unanimous approval of a designated group, such as the chairman of the FDIC, the chairman of the Federal Reserve Board, and the secretary of the Treasury. We would also urge Congress and American representatives on the Basel Committee to insist that the same minimum leverage ratios be required worldwide so there is a capital safety net for the international banking system.
The Basel II Fondue
Mix the following together:
- A base of complex rules nobody really understands.
- Twenty or more 800-pound U.S. banking institutions (other international varieties can be added).
- An assortment of opaque risk-based models (massaged to desired consistency, or inconsistency).
Add:
- A dozen or so seasoned but unsuspecting directors and senior executives.
- A smattering of the usual compensation incentives.
- A dash of human error (or a batch of hubris).
- A hint of moral hazard.
- A handful of regulators (AAA-grade regulators would be preferred, if available).
Whip into a frenzy and then pour into a pressure cooker over an open flame. Monitor carefully as bubbling will occur. If flames ignite, try not to get burned, and put out the fires as quickly as possible. But don't worry, the government authorities and their taxpayers are available in an extreme emergency.
