Following President Barack Obama's re-election, I argued financial reform would not be a priority for his administration, given other challenges such as job creation, gun control, housing policy reform and immigration. Recently, however, some politicians have been fired up over the "too big to fail" debate. Last Friday, a draft bill from Sens. Sherrod Brown, D-Ohio, and David Vitter, R-La., that would require banks to have higher capital requirements was leaked to the media.
Banks should definitely be better capitalized. The 2008 financial crisis illustrated that interconnected, large banks were overleveraged and undercapitalized. U.S. banks have yet to become Basel II compliant. In the U.S., Basel III rules have not even been finalized, much less implemented. It makes no sense for Brown and Vitter to scrap Basel III when its numerous components could empower bank regulators to increase the amount and quality of capital banks hold, especially for large banks. Also, if there are components that are not sufficiently stringent, U.S. regulators can strengthen Basel III so that banks pose less of a global systemic risk.
Some legislators and bankers love to paint Basel as un-American. Nothing could be further from the truth. In 1973, the U.S. and U.K., later joined by Japan, were the first countries to start discussing the Basel Accord, finalized in 1988. The U.S. became involved, because regulators finally understood how interconnected banking systems had become after Herstatt Bank collapsed in the early 1970s. Scrapping Basel III would send a signal to other countries that trying to have uniform, international capital standards is no longer a U.S. goal. U.S. banks would endeavor to find countries where capital requirements are lighter; regulatory arbitrage would be worse than it already is. If the U.S. were to renege on its commitment to the Basel accords, European banks, given their current condition, would have a perfect excuse to demand lighter capital rules.
Politicians and pundits are focusing disproportionately on the concept of risk-weighted assets, which is part of Basel's Pillar I, where guidance exists for the measurement of credit. This concept arose practically even before the first Basel was formalized. In the original Basel Accord, the risk weights were too simplistic, not risk sensitive and traders would gravitate to buying riskier corporate debt because the risk weight for all corporate debt, irrespective of probability of default, was the same.
The RWA concept is not unique. Why do we all pay different life insurance premiums? Gender, health history, danger of occupation, amount of travel and age are all the risk metrics which go into actuarial models to determine mortality. The sooner we are likely to die and the larger the benefits we want to leave our beneficiaries, the more that policyholders pay. Analogously, the higher an issuers' probability of default and the higher the loss severity will and should influence how much banks allocate for the level of risk of a particular issuer or borrower. Pillar I gives guidance as to the internal rating models banks should use in order to get permission from their regulators to derive their risk-weighted assets.
Will banks have substantially different RWAs either because their models differ or because they can manipulate the credit risk drivers? Yes. This year, the Basel committee released a study showing that banks have very disparate risk weights for market risks due not only to differences in models, but also due to supervisory judgment.
Importantly, a lot of the problem with RWAs could be solved if countries uniformly implemented and supervised Basel III's Pillar III, which provides guidelines for banks to be transparent about their on- and off-balance sheet activities. This pillar requires that banks disclose the quantity and quality of Tier I and II capital they have. Banks also have to mention what methodologies they use to calculate their credit, market and operational risk measurements. This information would be very useful for all types of investors, regulators, rating agencies and financial journalists.
Pillar III, in fact, has been part of Basel II since the mid-2000s. Presently, U.S. banks have not implemented it, and the European banks that are abiding by Pillar III, do not disclose information uniformly. Also, bank examiners have the right to question a bank if it is coming up with low risk weights that are not exhibited by other banks in the same peer group.
Very importantly, due to legitimate concerns about RWAs, other parts of Basel III are being ignored. What most people do not write about is that Pillar I also gives guidance to banks on how to measure unexpected losses due to market and operational risks. Operational risk especially continues to be the most ignored risk by Basel and by banks.
In addition to Pillars I and III, there is also Pillar II which provides, amongst other things, guidance to banks on how to conduct stress tests. Importantly, Pillar II provides guidance to the regulators on how to proactively insure banks are well-capitalized.
Not only have Basel III capital requirements increased significantly from Basel II, so have requirements for the quality of capital. Fortunately, under Basel III, U.S. regulators who have always been at odd with European ones on the definition of capital, won out. The emphasis now is on common equity and retained earnings which have true loss absorbency, the ultimate purpose of capital.
There are new buffers in Basel III for liquidity, leverage, capital conservation, procyclicality and systematically important financial institutions. By and large these buffers are a significant improvement from Basel II, but there certainly is room for improvement. Unfortunately, as we move away from the painful effects of the 2008 crisis, legislators and regulators globally are often swayed by bank lobbyists. The liquidity coverage ratio was watered down in early January. The final ratio now allows mortgage-backed securities and corporate debt to be included as part of the numerator, albeit with a haircut. The leverage ratio, a non-risk based buffer of 3%, is too low. In the U.S., the Federal Deposit Insurance Corp. has proposed several times this year that the ratio, especially for big banks should be higher. Given the role of overleveraged financial institutions in the U.S., if the FDIC proposal can gain traction, this would bolster Basel III
Given the significant costs of bank failures to society, prominent economists David Miles, Jing Yang and Gilberto Marcheggiano have recently argued capital requirements should be as high as 20%. Unlike what bank lobbyists will argue, their work found that having banks increase common equity as the only real loss absorbency capital does not impact the economy negatively. Douglas Elliott and André Oliveira Santos in their very in-depth work found that financial regulations did not increase lending rates substantially in the long run. The devastating and lingering effects of financial crises that impact everyone, especially those on Main Street, far removed from undercapitalized banks, warrant the higher capital and risk management requirements under Basel III.