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Basel III

Here are a few thoughts on Basel III.

First, and foremost, bank regulation must proceed on an international basis. Country by country approaches are unlikely to be successful given how easy it is to move funds to unregulated jurisdictions. Thus, any success in bringing about international cooperation on these issues should be applauded.

Second, is it a success? Yes, but not completely. The change from a requirement that banks hold 2% of equity in reserve, as under the old rules, to the current requirement of 7% was a necessary change. The additional reserves (i.e. reduced leverage) ought to reduce the fallout from a negative shock to the banking sector. With less need to unwind and more reserves on hand, the requirement should reduce the damages from financial meltdowns.

Third, what I don't have a good sense of is whether 7% is enough. I would have been tempted to go with the 10% requirement that was proposed by some countries out of an abundance of caution (which is justified by the severity of the consequences for innocent bystanders when things go sour). I also don't have a good sense of how porous the requirement might be. Some analysts believe banks can easily skirt the new rules, perhaps through innovation we haven't thought to preclude, while others believe the rules are fairly tight. My own view is that we won't be able to answer this until we see how banks respond. If they do respond by finding a way to skirt the rules, regulators will need to respond in turn. How well regulation requiring international cooperation can do this is an open question.

Fourth, while the new rules are needed, there's some question about the pace at which the capital adequacy ratios are being implemented. They won't be fully in place until 2018, which may not be fast enough to avoid trouble in the interim. The rules are intended to give banks the time they need to adjust, but the financial sector is noted for its flexibility in responding to unanticipated shocks, and they ought to be able to cope at a faster rate than this. But there are those who argue that even this pace is too fast.

Fifth, there is more to do. For example, I think banks are still too big and too interconnected, and the political and market power that size gives them needs to be restrained. For me, it's the political power that is the most worrisome, but the market power and implicit guarantee of a bailout that size gives them needs to be addressed (i.e. there are still moral hazard problems). The new rules in the US are supposed to allow us to wind down large banks without trouble, but when it comes time to actually allow a bank to go through this procedure, I have doubts that policymakers will have the courage to actually do it given all the unknowns associated with doing this for the first time, and will instead fall back on the type of bailout we saw this time around where the risks are easier to assess.

Thus, while this is a good step forward, it is unlikely to be enough on its own, and we need to continue to shore up the cracks in the system that make it vulnerable to collapse. There is still work to do.

Update: See here too: The Empire Strikes Back, by Avinash Persaud, Vox EU:

There are two remarkable aspects of the consensus around international financial regulation emerging in the run up to the November G20 meeting in Seoul. The first is that there is a consensus. International regulators are agreed that banks must set aside much more capital for risky assets; be less dependent on the whims of money markets; constrain the maturity mismatches between their assets and liabilities and set aside capital for holding complex derivatives where there may be settlement and clearing risks. They also agree that capital adequacy should move counter to the economic cycle and that banks should not be "too big to fail". Getting an international consensus around action that is sensible â€" save for the emphasis on "too big to fail"- is no mean achievement.

The second is that despite appearing to be down and out, the banking lobby has struck back, successfully making the case that all of these initiatives should be postponed or phased-in between 2015 and 2019. By then the pressure for regulatory reform could be a distant memory. Financial regulation veterans will be experiencing déjà vu. In each of the last seven international financial crises, plans for a radical shake up of international regulatory or monetary arrangements made surprising progress, only to be tidied away and stuffed in the bottom drawer once the economy recovered. Many of the new initiatives being proposed today have been pulled out of that same drawer, dusted down and updated.

The argument that the banking system is too broken and the world economy too fragile, to support more onerous regulations, is seductive for politicians desperately trying to boost consumer demand. But it is suspect. ... [...continue reading...] ...