Basel framework keeps growing more complex

Editor’s note: A version of this post previously appeared on FinRegRag, a blog by the scholars of the Mercatus Center Program on Financial Regulation.

During the last 10 years, we’ve lived through a banking crisis, an overhaul of the bank regulatory framework through the 2010 Dodd-Frank Act, and a revision of that overhaul through the 2018 Economic Growth, Regulatory Relief and Consumer Protection Act. Over the last 10 years the issue of what Dodd-Frank did and did not do has dominated the bank policy debate on Capitol Hill. Lost in the domestic debate is that a major driver of the rising regulatory burden facing U.S. banks over the last 30 years is the implementation of Basel capital adequacy standards.

I’ve already discussed, based on published empirical findings, how these capital requirements played a key role in the last financial crisis, and these capital requirements have been in a constant state of revision for the last 30 years. Below are several observations to consider about Basel’s increasing complexity, according to a recent paper I published with James Barth of Auburn University.

Observation No. 1: With each round, Basel guidelines add more measures

Basel I introduced the concept of risk-based capital requirements. Through accounting adjustments to measured capital and the reliance on arbitrary risk-weights that allowed banks to reduce the measured volume of assets that had to be backed by capital, risk-based capital have not served as a clear indicator of a bank’s net worth to investors. Investors will still turn to something like the market value of the bank’s stock or tangible common equity to gauge if it’s worth sticking with the bank.

Basel II therefore added the minimum common equity Tier 1 capital, which sounds more like the kind of measure that investors will track. But rather than supplanting existing measures, it merely supplemented them.

And then there’s Basel III, which added the capital conservation buffer, the countercyclical capital buffer and the surcharge for Global Systemically Important Banks. If that sounds complicated enough, Wharton professor Richard Herring had recently estimated that 75% of these capital requirements for large banks could be eliminated due to the redundancy that permeates the guidelines without weakening the standards.

Observation No. 2: The U.S. implementation of Basel guidelines has contributed greatly to regulatory complexity and verbosity

U.S. implementation of the Basel Guidelines has made bank capital regulation complex and verbose. Prior to Basel, bank capital requirements generated about 5% of all regulatory restrictions that apply to U.S. banking entities (i.e., words such as “may not,” “must,” “prohibited,” “required” and “shall”). That began to rise under Basel I, and by the time Basel III was unveiled capital requirements generate over 20% of all regulatory restrictions.

The paper also shows the effects on word counts. For instance, for the Office of the Comptroller of the Currency, Basel I capital regulations on average generated about 27,000 more words than other parts on the eve of Basel II’s implementation. Basel II generated almost 78,000 more words than other parts on the eve of Basel III’s implementation. Basel III generated over 157,000 words than other parts by 2017, when the sample ends. For the Federal Deposit Insurance Corp., Basel I capital regulations generated over 20,000 more words than other parts on the eve of Basel II’s implementation. Basel II generated almost 43,000 more words more words than other parts on the eve of Basel III’s implementation. Basel III generated over 103,000 words than other parts by 2017, when the sample ends.

Observation No. 3: Capital requirements are not created equally

Lastly, and perhaps most important, our research shows that for the largest commercial banks, these measures of capital adequacy did not all indicate whether a bank was inadequately capitalized. We're not the first to demonstrate this, but large banks all satisfied the Basel risk-based capital requirements through the crisis years, yet many of these large banks were undercapitalized if you used a measure like the market value of equity or the tangible common equity ratio.

The Basel guidelines arose from the International Lending Supervision Act of 1983, in the aftermath of the 1982 Latin American debt crisis, as Congress called on U.S. regulators to find a multilateral way to raise bank capital requirements, not just in the U.S. but in other countries. The “multilateral” way reflected concerns that U.S. banks were being punished relative to some of their competitors in France and Japan. From the outset, Basel reflected a political compromise. That compromise has turned into an increasingly complex regulatory framework that favors large, complex firms that are best suited to navigate through that complexity. Simplicity is a viable option, too.