Executive insight – Warring bankers line up on Basel III battle lines

Warring bankers line up on Basel III battle lines

More than three years after the start of the financial crisis and two years after the default of Lehman Brothers, the world economy is still struggling to climb back from the depth of the latest Great Recession.

The summer of 2010 has seen probably the quickest recovery pace since late 2008, thanks to the rebound in manufacturing, the resilience of China (and other Asian economies) and the fiscal stimuli enacted in early 2009, but the forecasts for the rest of the year are less upbeat.

One of the areas of major concern is the state of the banking sector. Until recently, the measures to tackle the aftermath of the crisis have been limited to unprecedented injections of money by taxpayers and liquidity from central banks (which also comes from taxpayers, just under a different heading).

Despite this, plans to revamp prudential regulations and buttress the pillars of the world’s financial architecture had remained on the drawing board. But on September 12, the Group of Governors and Heads of Supervision — the oversight body of the Basel Committee on Banking Supervision in charge of establishing the framework of international financial regulations — achieved a major breakthrough in a long and thorny negotiation round, announcing a substantial increase in banks’ capital requirements, even above the levels preliminarily agreed to in July.

The announcement was cheered by markets as quite positive for financial stocks, especially those banks seen as well capitalized, not least because the reforms will not be introduced immediately. In fact, the implementation by member countries of the Bank of International Settlements (BIS) is due to start on January 1, 2013, although national laws and regulations must be in place before that date, and the minimum common equity and tier 1 capital requirements will be phased in gradually between January 2013 and January 2015. All in all, that is more than five years of transition, a horizon hardly in line with the bombastic rhetoric on swift and draconian actions heard from politicians and regulators after the quasi meltdown of the international financial system and the trillions of dollars spent to rescue major banks.

Buffer boost

The BIS reforms will increase the minimum common equity from 2 to 4.5 percent of the banks’ risk-weighted assets (RWA). In addition, banks will be required to hold a capital conservation buffer of 2.5 percent to withstand potential losses during periods of stress, bringing the total common equity requirements to 7 percent. Tier 1 capital (i.e. including liquid financial instruments) will be increased from 4 to 6 percent of RWA (hence to 8.5 percent if one includes the conservation buffer) while total capital will reach 8.5 percent of RWA (or 10.5 percent with the buffer).

Although compliance with these ratios is due by 2015, in January 2013 the process will start with new mandatory minimum requirement ratios: 3.5 percent common equity/RWA; 4.5 percent tier 1 capital/RWA, and 8.0 percent total capital/RWA.

While banks will be able to use the conservation buffer during downturns, as their regulatory capital ratios approach the lower threshold, their dividend payments will be increasingly restricted. An additional countercyclical buffer up to 2.5 percent of common equity or other fully loss-absorbing capital (for example convertible bonds) will be left to the discretion of national authorities.

The purpose of the countercyclical buffer is to underpin macro-prudential stability, because risk piles up during booms, but materializes during recessions — hence the need to devise a mechanism for reining in the banking sector’s excessive credit growth in good times and sustain lending to the enterprises during bad times. Finally, systemically important banks will be subject to stricter loss-absorbing capacity beyond the standards announced, but specific measures are still being debated and were undergoing a consultative process as Executive went to print.

A sense of déjà vu

The new regulatory framework is certainly a step in the right direction, although given the harsh lessons from the crisis it could have been more ambitious. One can be forgiven for suspecting that the boost to banks’ shares was not only a sign of relief for the delayed implementation of the new prudential parameters, but also an acknowledgement that the new rules are not as strict as feared by bank executives. Nevertheless, it is likely that national authorities will go beyond the BIS standards (which set merely a minimum common criterion), especially in Europe.

Rather than being the final word, the agreement reached at the Basel Committee on Banking Supervision represents merely the initial salvo in a battle that will be fought on many fronts: accounting rules for financial instruments, definition of risk weights, powers of inspection by supervisors, countercyclical buffers and so on. Unfortunately there is never a simple receipt for ensuring the stability of financial institutions.

It is a recurrent problem and it dates back to the dawn of modern finance (and arguably earlier). For example, the Austrian economist Ludwig von Mises, writing in 1928 about the monetary policy of the Bank of England during the 19th century, observed:

“It was usually considered especially important to shield the banks that expanded circulation credit from the consequences of their conduct. One of the chief tasks of the central banks of issue was to jump into this breach. It was also considered the duty of those other banks that, thanks to foresight, had succeeded in preserving their solvency, even in the general crisis, to help fellow banks in difficulty.”

Some 10 years later, Von Mises’ colleague and friend Friedrich von Hayek  commenting on the Peel Act, a law forbidding the extension of bank credit in England through banknotes (but not through deposits), observed that each time there was a financial crisis the Peel Act was suspended. From these episodes he drew a damning conclusion:

“The fundamental dilemma of all central banking policy has hardly ever been really faced: the only effective means by which a central bank can control an expansion of the generally used media of circulation is by making it clear in advance that it will not provide the cash (in the narrower sense) which will be required in consequence of such expansion, but at the same time it is recognized as the paramount duty of a central bank to provide that cash once the expansion of bank deposits has actually occurred and the public begins to demand that they should be converted into notes or gold.”

Does it sound familiar? It should, because it is exactly what happened in the aftermath of the financial tsunami in the fall of 2008 and is still happening today with quantitative easing and other creative ways of describing money printing by central banks.

Indeed, like the Peel Act, the articles of the Amsterdam Treaty forbidding the European Central Bank to monetize the public and private debts have been suspended (or thrown to the bushes). Hence, it is not surprising that the gold price is setting new records.