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.