Courtesy Reuters

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.

Despite the upbeat headlines about Basel III, many of the most important questions have yet to be answered. For example, should banks that are short of capital be allowed to increase their dividends to shareholders? Should the very largest banks be required to be better capitalized than smaller ones because their failure would do so much more damage to the world economy? Should the owners of bank bonds have to sacrifice part or all of their investment if their bank requires government assistance? And should banks be required to establish locally regulated subsidiaries in order to prevent them from moving money into and out of foreign branches without local oversight?

In principle, the answer to each of these questions should be yes. Higher capital requirements for “systemically important” banks and mandatory bondholder concessions would counter their most important advantage over smaller banks -- the ability to borrow cheaply because investors believe that the government will keep big banks from failing. And mandating local subsidiaries will reduce banks’ ability to shuffle money seamlessly across borders and increase the power of national regulators.

But banks in many countries are resistant to tougher rules and are aided by friendly politicians. Indeed, despite the recent global financial crisis, many political leaders are signaling their banking regulators to go slowly with banking reform. Their biggest concern -- and one the banks have played up -- is that stricter rules will cause banks to restrict lending at a time when the world’s economies desperately need banks to make new loans to spur growth. But curtailing lending is precisely the point of Basel III: after all, it was lax loan practices -- loans to homebuyers that were worth more than the value of their homes; packaging loans into securities that defaulted within months of issuance -- which got the banks into trouble in the first place.

Politicians also fret that tougher regulation will weaken the ability of domestic banks to compete internationally. This concern is misguided. Indeed, Basel II’s weak standards, which contributed directly to the recent financial crisis, were a response to politicians in Europe, North America, and Japan who wanted to level the financial playing field for their banks. And there is little evidence that financial activity is shifting to countries where the rules are more lenient. If anything, the big banks’ most important customers want to do business in places where regulatory oversight is strong, because heavy regulation and a reliable legal system increase the odds that a bank will meet its obligations.

Perhaps Basel III’s biggest problem is that no matter how reasonable the new standards, the Committee on Banking Regulations and Supervision has no power to enforce them. Real reform of the international financial system will depend on turning Basel III into domestic policy. Only national governments can establish and enforce regulations on banks operating in their territory. And only national governments could be held politically accountable for regulatory failures. Their appetite for doing so remains to be seen.

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