Financial Re-Regulation

Basel III’s Unfulfillable Promises

By the time the presidents and prime ministers of the G-20 countries gather in November for summit talks in Seoul, the world’s banking regulators will have developed an entire package of new global banking standards for their enthusiastic approval. The regulators are already on a roll: on September 12, they approved tougher capital requirements to prevent future financial crises, and on September 22, they discussed passing even harsher regulations for the biggest banks. But the extent to which this so-called Basel III accord will make the world economy safer is far from clear. As I argued in the May/June 2010 issue of Foreign Affairs, the stability of the financial system depends not on such high-profile international agreements but on decisions taken and enforced at the national level once the spotlight is turned off. Indeed, the real work still lies ahead.

Basel III, developed by the Committee on Banking Supervision -- a forum of 27 member nations that meet in Basel -- is meant to address problems created by the previous Basel standards. Their first agreement, developed among 11 countries in 1988, was a simple and largely successful effort to contain the effects of bank collapses, by requiring big banks worldwide to hold larger capital reserves (unencumbered funds that ensure a bank can meet its obligations). The 2004 Basel II agreement, meant to modernize Basel I, was a disaster. It allowed many banks to decide for themselves how much capital they needed at hand and even encouraged them to minimize their capital requirements. Its capital requirements encouraged Banks to package high-risk loans into securities and sell them to investors, rather than retaining them as assets on their own books. By raising the cost of risky activities and requiring more ready funds, Basel III aims to make big banks more resilient in the face of losses from bad loans or bad trades, more able to cope with sudden surges in depositors’ demands for cash, and more prepared to shut down business should downturns in their financial fortunes become too much to bear.

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