Will Basel III's Capital Requirements Make the Financial System Safer?

Last Updated Sep 17, 2010 5:55 AM EDT

Simon Johnson does not think the capital requirements in Basel III are strict enough:
Picking Up the Slack on Global Banking Rules, by Simon Johnson, Economix: ... The Hanson-Kashyap-Stein view ... is that banks should be required to hold enough capital at the peak of the cycle so that when they suffer losses..., they still have enough capital so that the markets do not think they will fail. Therefore, they have no need to dump assets in a desperate bid to survive. (It's the forced asset sales of this nature that turn financial distress at particular institutions into broader asset price declines, which can lead to panics.)
The logic here points toward at least 15 percent Tier 1 capital being required in good times; the most forward-looking officials in Group of 20 countries may aim for closer to 20 percent (Tier 1 is a good measure of loss-absorbing capital -- what stands between the bank and insolvency). ...
Treasury Secretary Timothy F. Geithner is fond of saying that the appropriate response to the crisis -- and the way to prevent any kind of recurrence -- is with "capital, capital, capital." The Dodd-Frank financial regulatory act did not raise capital requirements; the Treasury insisted on deferring to the Basel III process. Basel III, we learned over the weekend, is on course to raise capital requirements -- but only to a level below what American banks have held on average in recent decades. (For Tier 1 capital, Basel III posits 8.5 percent at the end of the day; American banks fluctuate roughly around 10 percent).
The best chance -- and perhaps the only one remaining -- is for the United States to insist on stronger capital requirements for domestic financial institutions, as permitted, even encouraged, in Basel III under the heading of "countercyclical buffer." And systemically important financial institutions, for which the Basel process appears to have completely dropped the ball, should be subject to even higher requirements. This should be coordinated with Britain (where there is already thinking in the right direction), Switzerland (again, forward-thinking officials hold sway), and anyone else who can be brought on board.
The "systematically important" reference is to banks that are too big to fail (see here and here for a discussion of that issue).Under proposals like Simon Johnson describes, in addition to being stricter, capital requirements would vary in two ways, over the business cycle and between systemically and non-systemically important firms. Over the business cycle, capital requirements would be higher in good times to discourage excessive risk taking, and lower in recessions when financial institutions are reluctant to take risks. Along the size dimension, capital requirements would be higher for systemically important firms to dissuade them from taking on too much risk and endangering the financial system.

I think this is a good idea, and I've been a strong advocate of strict capital ratios to limit the amount of leverage financial firms can take on. Limiting leverage is an important means of limiting the damage that a large shock can do. Having capital requirements vary over the business cycle and by the size of institutions is also something I support.

But one worry is that these limits may not be as strict as we intended. For example:
Capital can't be measured, by Steve Waldman, Interfluidity: ...Sure, "hard" capital and solvency constraints for big banks are better than mealy-mouthed technocratic flexibility. But absent much deeper reforms, totemic leverage restrictions will not meaningfully constrain bank behavior. Bank capital cannot be measured. Think about that until you really get it. "Large complex financial institutions" report leverage ratios and "tier one" capital and all kinds of aromatic stuff. But those numbers are meaningless. For any large complex financial institution levered at the House-proposed limit of 15×, a reasonable confidence interval surrounding its estimate of bank capital would be greater than 100% of the reported value. ...
Given these facts, and I think they are facts, even "hard" capital and leverage restraints are unlikely to prevent misbehavior. Can anything be done about this? Are we doomed...?
Yes, we are doomed, unless and until we simplify the structure of the banks. ... Capital does not exist in the world. It is not accessible to the senses. When we claim a bank or any other firm has so much "capital" we are modeling its assets and liabilities and contingent positions and coming up with a number. Unfortunately, there is not one uniquely "true" model of bank capital. Even hewing to GAAP and all regulatory requirements, thousands of estimates and arbitrary choices must be made to compute the capital position of a modern bank. ...
Regulation by formal capital has a proud and reasonably successful history, but has been rendered obsolete by the complexity of modern financial institutions. The assets and liabilities of a traditional commercial bank had straightforward, widely acceptable book values. For the corner bank, discretionary modeling mattered only in setting credit loss reserves, and the range of estimates that bank officers, external auditors, and regulators would produce for those reserves was usually pretty narrow... But model complexity overwhelms and destroys regulatory capital as a useful measure for large complex financial institutions. We need either to resimplify banks to make them amenable to the traditional approach, or come up with other approaches more capable of reigning in the brave new world of banking.
This is a point that hasn't received enough attention in the discussion of the new capital requirements in Basel III. If banks can easily skirt these requirements through their accounting choices and still stay within regulatory requirements -- and the argument above is that this is both possible and likely -- then these requirements will not provide as much safety as anticipated by many analysts. As I noted here in a different context, this is why we need to pursue an array of policies intended to reduce the vulnerability of the financial system to collapse. Too much reliance on a particular approach is a recipe for disaster.
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