Friday, September 28, 2012

Why Basel III won’t work

After the Ferbruary post on the flaws of Basel III regulation (see discussion) we got a number of emails pointing to the importance of uniform global banking rules. "By criticizing Basel III you support these banksters" was one of the comments. Of course the wrongs of banking could be set right by new rules - even if they are a messy modification of an earlier set of regulations that got large banks (like Citi) into trouble to begin with (see discussion from 2009).

But many professionals in the financial services industry continue to support Basel III, in part because it benefits them. Most people don't fully appreciate how much business the major international accounting/consulting firms for example get from engagements to implement new capital rules at banks. That's why it's no surprise that many advocates of (and experts on) this "enhanced" regulation just happen to be consultants from the Big 4 and other large accounting firms. Nothing wrong with consulting, but there is a bit of a conflict here.

Clearly some of the new rules are important - particularly those dealing with adequate liquidity. But the prescriptive methods used to solve every possible concern dealing with capital and liquidity will push financial organizations to focus on the "letter of the law" instead of the "spirit of the law". And loopholes will inevitably arise (as they did with Basel I) creating more systemic risks.

Some of the problems with Basel III are laid out in this excerpt from a well written article on Bloomberg Brief. The implementation issues emerging from the new regulatory framework are troubling indeed.
Karen Shaw Petrou (Federal Financial Analytics): - ... Basel Committee rewrote its capital book in 2010 and, for good measure, added needed global liquidity standards.

Two years later, though, and each of these axiomatic standards remains unimplemented in almost every major banking center. Some have suggested that, with just a bit more gumption, the Basel rules will jump national borders to conquer risk. But, like it or not – and I don’t much like it – Basel can’t work.
...
The global capital and liquidity standards codified as Basel III have important weaknesses of their own – most important among them undue complexity resulting from a hopeless effort to address every nuance in each major banking market under each applicable accounting scheme in all circumstances. But, even if Basel were better, it couldn’t be consistently implemented in comparable fashion across borders no matter how well meaning the national regulator.

The reasons for this are statutory and structural. First, many nations – the U.S. is a prime case – have laws that override key tenets of Basel III. For example, the U.S. bans reliance on credit ratings, which means that its risk judgments are substantively different from those that underpin Basel III. The European Union is considering a law that side-steps implementation of the Basel leverage ratio – a critical reform meant to prevent all the risk-weighting games still shockingly evident across the globe. And, even where law permits imposition of Basel’s key provisions, it often doesn’t let supervisors actually enforce tough capital rules – mooting the point.

And, even if there weren’t these statutory barriers to Basel III, profound structural ones bar comparable crossborder capital and liquidity standards. One of the most important here is the U.S. commitment to community banks, for which Basel is in many ways inappropriate. Even if one carved out community banks, the U.S. still has 34 bank holding companies with assets over $50 billion, a sharply different and more diverse banking system than found almost everywhere else.

Even more significant, the U.S. now has a combination package of statutory and structural barriers to Basel III. The Dodd-Frank Act created an “orderly liquidation authority” (OLA), a new law that will end too big to fail by barring taxpayer support for large banks. In sharp contrast, the European Union and many other nations have banks that are not only backed by too big to fail, but also “too big to save” expectations by virtue of national reliance on only a very few, very large banks.


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