For years, the Basel Committee's capital rules went virtually unnoticed despite the profound impact regulatory capital has on bank profitability, competitiveness and line-of-business decisions. Basel III isn't, though, following I and II into obscurity, with recent editorials in The New York Times and The Washington Post focusing on the new capital and liquidity standards.
Attention has largely centered on claims that banks have so watered down Basel III that a new, capital-driven crisis looms. To be sure, the late-July Basel III agreement took out a few teeth from the formidable array of fangs Basel bared in the December consultative papers. But, the new standards will still bite hard into bank strategic assumptions, with the U.S. ones mandated by the Dodd-Frank Act sure to tear even bigger holes into business.
To assess this strategic impact, it's vital first to have a clear sense of what Basel III will do and how that does or doesn't jibe with Section 171 (often called the Collins amendment) and other capital-related provisions in the Dodd-Frank Act. Then, one needs to know what capital requirements do and don't do to bank strategic decisions. From this, winners and losers emerge.
One reason critics have been harsh about Basel III is that each compares the new regime to his or her own idea of capital perfection. As with judgments about truth and beauty, this is a dangerous path, as each of us also has our own idea of the ideal, most often unattainable by mortal effort. Thus, a real-world evaluation of Basel III needs to remember that it's the product of complex, global negotiations.
That anything emerges at all is an achievement. That what came out is remarkably close to what most analysts call reasonable, even if not ideal, is then striking. Finally, that this time around, the Basel negotiators didn't take a full decade to deliberate is notable (although here we won't spread much praise because the reason for unusual alacrity was the global financial crisis in part wrought by all the years of Basel indecision that went before).
But, so far, not so bad. Then, too, a real-world judgment about Basel III needs to compare it to Basel I and II. If not perfection, Basel III is at least a darn sight better than what went before — a point, by the way, on which even the most perfection-minded Basel critics agree. If Basel III is better, even if not the best, to send it back to the drawing board now will either leave Basel II in place or, worse still, create a vacuum of continuing uncertainty over global capital rules that will further delay recovery.
Basel critics also forget the tough standards finalized in 2009 set to go into effect next year. These address resecuritization — one source of the crisis — and the trading book (that is, market-risk-related capital). Much here is highly technical, but the bottom line isn't. The trading-book rules will, for example, boost capital in this part of the business by as much as 600-700%, contributing to the global rewrite of bank trading activities inside and outside the U.S. Here, of course, the Volcker Rule will add still further impetus to a strategic rewrite of bank capital-market activity.
And, anything Basel can do, the U.S. will do tougher. That's the mandate Congress has now given the U.S. banking agencies. And, Congress told the banking agencies not only to do Basel tougher, but also to do it faster.
The Dodd-Frank Act sets out a two-tier capital system: a "generally applicable" one for most banks and a still more stringent one for systemically vital institutions. The current U.S. capital standards are the floor for the new framework, meaning that anywhere Basel III gives a little, the U.S. will have to take it back.
Advocates of this approach pushed for it to cement standards like the U.S. leverage rule more or less as is. But, this takes no account of everything else under consideration in Basel III and mandated elsewhere on capital in Dodd-Frank. Thus, U.S. capital rules will pile one charge atop another — that's what the law says — instead of calibrating regulatory capital to better reflect real risk and, even more important, reward those who don't take it.
But, like it or not — and I don't — that's the law. In fact, Congress this fall will push to ensure its tough tone is taken to heart. Worried by all the press suggesting big banks won in Basel III, hearings are on tap to chastise regulators wherever any give was granted.
Finally, to why capital matters so much. Suggestions that regulatory capital doesn't count for much are often based on academic models that have considerable value in their own context but don't fit well with bottom-line business judgment. Models notwithstanding, strategic decisions are — or at least should be — based on two capital-driven factors: risk-adjusted return on capital, which drives line-of-business capital allocation, and return on equity, which tells investors what they can expect to receive in return for their tangible common equity.
Change the C in RAROC and the E in ROE and these equations change a lot. Thus, when regulatory capital adds a kicker to the C in RAROC, banks reallocate capital or take more risk to make the numbers work to their satisfaction. It was precisely this balancing act that took banking off the rails before the crisis. Capital didn't capture risk well, so banks drove risk up to make RAROC rock. Bank regulators now will try to capture risk through new prudential rules that come in tandem with risk-based capital ones, but how well this works will dictate where regulatory-arbitrage opportunities remain.
While RAROC drives internal line-of-business capital allocation, ROE tells investors whom to love. Thus, differences in regulatory capital between U.S. and non-U.S. banks and between banks and nonbanks at home and abroad will remain profound strategic drivers in the postcrisis marketplace. As before the crisis, regulators can control capital standards only for those under their sway, with "shadow" banks largely outside the capital sphere unless they trigger systemic regulation under the Dodd-Frank Act. This leaves the "shadow" banking system much as it was before the crisis, even though banks are about to come under tough new rules that will be even more formidable in the U.S.