A viable alternative to Basel III prudential rules

Stefano Micossi

Global banking regulation is undergoing a massive reform, known as Basel III. This column argues that the proposed reforms will fail to correct flaws in the old system. The new rules are even more complicated, opaque and open to manipulation. What is needed is a radical shift to prudential rule based on a straight capital ratio.

There is something surreal in the process for the implementation of the new Basel capital framework for banks in the EU and US. The new rules, known as Basel III, have the full support of financial officialdom (see BCBS 2013b for the latest official update by Basel Supervisors). Implementation is a different story. Implementation appears fraught with frictions and resistances, while the system is by now utterly discredited in the eyes of financial markets and academia (e.g. Dewatripont et al. 2010, Goodhart 2013, Admati and Hellwig 2013).

Radical criticism has been voiced also by top regulators (e.g. Hoenig 2013, Haldane and Madouros 2012, and Tarullo 2008 on Basel II). In recent research, I propose shifting to a prudential rule based on a straight capital ratio (Micossi 2013 ). My work also argues that the often-rehearsed arguments against this solution are plain wrong.

What’s wrong with Basel rules?

My main criticism concerns the continuing reliance – for the determination of capital requirements – on banks’ risk-weighted assets calculated with unwieldy probabilistic econometric models of dubious analytical foundation that leave ample room for gaming the system and, more importantly, that are by construction unable to deal with systemic shocks hitting the banking and financial system (IMF 2009, FSA 2010, Haldane 2011, Carmassi and Micossi 2012).

After ignoring the issue almost entirely during the negotiations leading to the Basel III Accord, Basel supervisors have awoken to the reality of wide divergences in risk-weighted asset ratios to total assets for individual banks and are studying the issue as part of their new Regulatory Consistency Assessment. Their January 2013 report finds that ample risk-weighted asset variations can only in part be explained by differences in business models and risk management techniques, and reflect to a considerable extent “elements of the flexibility provided to banks and supervisors within the Basel framework” (BCBS 2013). Similar exercises undertaken by the European Banking Authority have come to similar conclusions (EBA 2013).

In this context, the new Liquidity Coverage and Net Stable Funding ratios are but another manifestation of Basel rules’ inability to protect financial stability. However, far from responding to a clear rationale, they have added new patches on a crumbling construction. Their costs and impact on banks’ operations have not been evaluated but may be substantial; and fierce industry lobbying, already under way, is likely to lead over time to their emasculation. As if this were not enough, important jurisdictions are also intervening directly to prohibit trading on one’s own account (the Volcker rule in the US) or impose structural separation between commercial (‘utility’) and investment banking (the Vickers ringfencing in the UK). In the EU, the Liikanen Report has brought up for consideration the possibility of segregating banks’ trading activities into a separate legal entity – with tortuous decision procedures to ensure that it doesn’t happen in practice.

The Basel system has also failed to create a level playing field for ‘internationally active’ banks as divergent implementation by national supervisors has increasingly ‘balkanised’ it across the main jurisdictions – a process that Basel III special treatments will worsen.

Finally, Basel rules made it possible for the banking system as a whole to operate with a very thin capital cushion and a very high aggregate leverage, laying the basis for the subsequent implosion of credit when the financial crisis struck. The problem has not been resolved by Basel III, which will permit individual banks to keep a capital buffer as low as 3% of total assets – corresponding to a total leverage ratio above 33.

In sum, Basel III has to provide banking supervisors and markets with a readable metric of banks’ strength. Piecemeal fixtures won’t suffice; a complete overhaul of the system is in order.

A fresh start

In our Centre for European Policy Studies (CEPS) paper, Jacopo Carmassi and myself (2012) have outlined a logical and complete prudential system for banking that is much simpler and less distortive, entailing five components:

First, capital requirements set as a straight ratio between common equity and total assets.

Its level should be (gradually) raised to between 7% and 10% of total assets, based on systemic stability considerations. The new capital ratio, with equity valued at market rates, would be used as a reference in both Pillar 2 (supervisory review) and Pillar 3 (market discipline).

Second, under Pillar 2, prudential capital ratios would be used to trigger enhanced supervisory review and bind supervisors to a set of predetermined corrective actions of increasing severity, when the bank’s capital ratio falls below certain pre-specified thresholds, as under the current US FDIC system of PCA.

Third, in order to eradicate moral hazard, the system must be ‘closed’ by a procedure for bank resolution, to be triggered when a bank’s capital falls beyond repair.

Resolution costs would fall primarily on shareholders and unsecured creditors but even secured creditors and uninsured depositors would not be sure to escape.

Fourth, the correction for risk-taking by individual banks would be entrusted to deposit insurance, that would cover retail depositors and only up to a maximum amount.

Fees would be determined on the basis of banks’ overall risk profile and systemic relevance, as will be described below.

Fifth, under Pillar 3 (market discipline), solvency rules would be completed by the obligation for banks to issue a substantial amount of contingent capital (Co.Co.), i.e. debentures convertible into equity;

It is important that conversion be triggered automatically upon crossing certain market-based capital indicators and not be left to supervisory discretion (as in a misguided proposal by the Commission, 2012).

Under this system, there would be no need for special rules on liquidity or funding structures, whose adequacy would be concretely verified within the supervisory review of the banks covering the overall business model, its riskiness and its sustainability. There would also be no need for special restrictions on particular activities and operations, since supervisors would be able to penalise risk-taking as needed with deposit insurance fees.

Mimicking the Federal Deposit Insurance Corporation deposit insurance system

The system just outlined places a special burden on deposit insurance, that which becomes the sole instrument for charging individual banks for the risk they pose for the deposit insurance fund and financial stability in general. Therefore, it seems useful to recall that this approach already has an important precedent in the system of deposit insurance developed by in the US by the Federal Deposit Insurance Corporation, under the Federal Deposit Insurance Act, based on the so-called ‘CAMELS’ ratings system (that is, a ratings system based on capital, assets, management, earnings, liquidity and sensitivity to market risks).

Deposit insurance fees are determined based on the probability that an institution may cause a loss to the deposit insurance fund due to the ‘compositions and concentration’ of the institution’s assets and liabilities, and seeks to price all aspects of risk-taking by an individual institution and their systemic relevance. The system is open to periodic adaptations to the evolving banking business; apart from this, it seems to require no complements in the form of ad hoc capital surcharges or special constraints on banking activities and legal structure.

The ‘arbitrage’ objection to a straight prudential capital ratio

A main objection to this approach is that the elimination of all risk adjustment in the determination of prudential capital ratios would create fresh opportunities for regulatory arbitrage by banks seeking to maximise their returns on equity. This is an old argument that played a paramount role in the demise of Basel I and the adoption of risk-based capital ratios in Basel II (Tarullo 2008). It also happens to be groundless.

Indeed, the arbitrage objection assumes that the bankers’ only goal is to maximise returns on equity regardless of risk. Unless we believe that bankers’ utility function is characterised by zero risk-aversion – a rather worrisome presumption, which, to my knowledge, has no empirical confirmation – the only explanation for that kind of behaviour can be perverse incentives created by regulation and systematically encouraging bankers to take reckless risks.

And indeed there is plenty of evidence that legal rules and financial-market regulations have created moral hazard by shielding bankers form the consequences of their mistakes (or reckless gambles). This is, for instance, a straight consequence of the legal provision of limited liability; of the promise that, in case of difficulty, the bank will enjoy special access to the central-bank liquidity facilities; of the implicit promise that the bank will not be allowed to fail.

Far from creating new opportunities for regulatory arbitrage, the shift to a straight, risk-unadjusted capital ratio would reduce them, relative to the present system, as current incentives to manipulate internal risk management models, in order to reduce capital absorption, would disappear.

Conclusions

The Basel framework for bank prudential requirements is deeply flawed; the Basel III revision has failed to correct these flaws and in the main has made the system even more complicated, opaque and open to manipulation. In practice, the present system does not offer regulators and financial markets a reliable capital standard for banks; its divergent implementation in the main jurisdictions of the EU and the US has broken the market into special fiefdoms governed by national regulators in response to industry interests. The time is ripe to stop tinkering with minor adjustments and radically change the system.

References

Admati A and M Hellwig (2013), The Bankers’ New Clothes, Princeton University Press.

Basel Committee on Banking Supervision (BCBS) (2013), “Regulatory consistency assessment programme (RCAP) – Analysis of risk-weighted assets for market risk”, Basel, January (revised in February).

Carmassi, J and S Micossi (2012), “Time to Set Banking Regulation Right”, CEPS Paperback, Brussels, March.

Dewatripont, M, JC Rochet and J Tirole (2010), Balancing the banks: global lessons from the financial crisis, Princeton, NJ, Princeton University Press.

European Banking Authority (EBA) (2013), “Interim results of the EBA review of the consistency of risk-weighted assets. Top-down assessment of the banking book”, London, 26 February.

European Commission (2012), “Proposal for a Directive of the European Parliament and of the Council establishing a framework for the recovery and resolution of credit institutions and investment, COM(2012) 280 final, Brussels, 6 June.

Financial Services Authority (FSA) (2010), “Results of 2009 hypothetical portfolio exercise for sovereigns, banks and large corporations”, March.

Goodhart, CAE (2013), “Ratio Controls need Reconsideration”, Journal of Financial Stability, 20 February.

Haldane, AG (2011), “Capital discipline”, speech to the American Economic Association, Denver, CO, 9 January.

Haldane, AG and V Madouros (2012),”The dog and the frisbee”, paper presented at the Federal Reserve Bank of Kansas City’s 36th economic policy symposium, “The Changing Policy Landscape”, Jackson Hole, Wyoming, 31 August.

Hoenig, T (2013), “Basel III Capital: A Well-Intended Illusion”, remarks to the International Association of Deposit Insurers 2013 Research Conference, Basel, 9 April.

IMF (2009), Detecting Systemic Risk, Global Financial Stability Report, Washington, DC, April.

Micossi S (2013), “A Viable Alternative to Basel III Prudential Capital Rules”, Ceps Policy Brief No. 291, Brussels, 30 May, available at http://www.ceps.eu/book/viable-alternative-basel-iii-prudential-capital-....

Tarullo, D K (2008), “Banking on Basel. The future of international financial regulation”, Peterson Institute for International Economics, Washington DC.