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Basel III Misses the Point; Bankers Will Still Cheat the Rules

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The Basel III Accord won't have enough of an impact on Wall Street to dissuade another financial crisis.

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I'm not a banker. So when I sat down this week to pry apart the intricacies of the new capital adequacy standards agreed to over the weekend in Basel, Switzerland, the details were less than enthralling. Nevertheless, there's something to be said for trying to keep investors and consumers safe from the falling concrete of a crumbling bank. But after several hours of reading, including a glance at the first blush reactions of the Financial Times and Wall Street Journal crowd, I came to the conclusion that the whole lot of rules were just dumb.

Okay, perhaps that isn't the most sophisticated conclusion.

My more nuanced perspective is that while the overall new design for capital requirements is well-intended, and might be more prudent than previous iterations of international banking standards, the Basel III Accord misses the main lesson of the global financial crisis: Over reliance on regulatory structures decreases incentives for financial institutions to watch their own backs.

The Basel agreement this past weekend was impressive in some regards. The last banking standards treaty, finalized in 2004, took 10 years to negotiate. The new rules, developed over just one year, kick that long contemplated set of standards to the curb. Clearly the old rules failed to prevent banks from taking on too much risk.

In fact, they were part of the cause of the increased risk in the system, as banks focused on packaging up toxic mortgage debt into securities that required significantly lower capital to be held in reserve than if the very same mortgages were owned individually. And to top it all off, Fannie Mae and Freddie Mac weren't required to follow Basel capital rules at all. The build-up of toxic mortgage-backed securities with AAA ratings, promoted by the carefree GSEs, hid away the rise in poor-quality mortgages on bank balance sheets and allowed the farce to go on longer than it ever should have and spread wider than it ever would have in a world where bankers had to bear negative consequences of their mistakes.

Pondering this history, it struck me as odd that the people who spent 10 years designing the last system, which failed, were writing the new rules. It's almost like letting John Travolta direct a remake of Battlefield Earth.

Basel II was supposed to ensure banks had enough cash on hand to cover potential losses. Instead, the Basel II rules completely missed the risks building up in the system. And while on the subject, the first Basel Accord was intended to provide guidance to banks on ensuring proper capitalization, but was surpassed by financial innovation, and didn't help stop the Japanese banking collapse in 1990, leading to the Lost Decade.

The backwardness of designing the new backing capital requirements on the old framework was apparently lost on the world's central bankers as they gathered to improve on their past failures. But given the current regulatory climate around the world, the imprudence of simply abandoning detailed banking standards overnight is understandable.

Moreover, since the Dodd-Frank Act left the tacit "too big to fail" system in place for the United States and the European Central Bank has created a bailout fund for member nations (and the banks that own their debt), financial institutions don't have the necessary incentives to properly police their own capital. So, in this less-than-ideal regulatory environment, some kind of standard is necessary.

Still, Basel III leaves much to be desired as an international capital adequacy agreement. There are three problematic themes that register worry in my non-banker psyche.

First, the new system is overly dependent on the all-knowing wisdom of regulators. While banks will have to keep a minimum of 4.5% of common equity and 6% of Tier 1 capital, they will also be subject to a 2.5% "capital conservation buffer." This buffer will be triggered in good times, so that banks can be more stable during financial crises. But there's no objective trigger point for when banks will need to build up the buffer and when they will be allowed to draw on that capital if needed. This decision will be left up to regulators in each individual country.

The problems with this shouldn't be hard to imagine, since we have the past decade as a good example for what happens when regulators are put behind the wheel while they're asleep. As the housing bubble built up, the Fed, FDIC, SEC, and Treasury all had the authority needed to identify the systemic risks building up in the system.

But not only did their analysis miss the canyon they were driving into, but when alerted to the possibility of an abyss ahead, their response -- at least from the Federal Reserve -- was to say they would only mop up after a car crash, not prevent one.

Trusting regulators to act on their authority takes some willpower. Believing that regulators will time the market right for when banks should hold more capital or not is more like a leap of faith. And let's not forget the uncertainty this will inspire in the marketplace.

Second, the rules are blunt and arbitrary. How do we know that 4.5% is high enough? Or that a 2.5% buffer will hold up in financial storm?

The Shadow Financial Regulatory Committee, based in Washington, DC, released a statement on Monday arguing that the minimum common equity ratio was too low, since most of the financial institutions that took bailout cash were over or at that ratio during the crisis.
However, up until the final moments of the discussion over the weekend, Germany was voicing concerns that proposed levels were too high. Understandable, as Deutsche Bank (DB) has one of the lowest capital reserves at the moment.

Further still, the capital ratio requirements are going to be relatively meaningless if the assets they're measured against get overvalued. This means ensuring proper accounting methods, which the Financial Accounting Standards Board has been grappling with, but failed to get right during the crisis. (Though who wants to keep debating mark-to-market rules?)

Even if there was a good defense for the agreed upon percentages, the choice of arbitrary risk weights is a blunt tool that doesn't seem appropriate for the dynamic nature of the global banking industry. "In terms of the countercyclical buffer, you have a bald number to protect against excess credit, but bubbles tend to affect individual asset classes at different points in time so it's a blunt instrument," argues Richard Barfield, director at PriceWaterhouseCoopers. "To manage risk you have to be more targeted."

Finally, the complexity of the rules doesn't make sense. Basel II had a "three pillars" approach, but Basel III is broken down into "four layers" of capital requirements. European Parliament member Sharon Bowles calls them the base layer, the warning layer, the buffer layer, and systemic layer.

While an extra layer of defense may appear at worst innocuous, it should be remembered that the failure of capital requirements wasn't that they were set too low, but that they were too static and got out-navigated by a market that took advantage of the over complex nature of the old system to build up mountains of risk right in front of inept regulators.

Banks should be able to set their own capital requirements, but if the government is going to do it for them, then a single, simple, significant reserve level would avoid depending on regulators to time the market and help investors more easily understand the safety and soundness of banking institutions.

It wouldn't be a perfect system. It would stumble into the same trap of arbitrary standards. And it would need to take into account the different types of banking institutions in the market to be less blunt than Basel III. But hopefully it would bring more objectivity and certainty to the marketplace.

In an ideal world we wouldn't need to have these, well, dumb rules. But since this and other criticism is unlikely to change the Basel rules in the near future, the market will need to prepare for the next crisis. To put our faith in the regulatory designs of the same men who failed to detect or prevent the financial crisis is silly enough. But to believe that bankers won't find their ways around the new laws or manipulate them for gain while putting the taxpayers at risk, is cognitive dissonance at best.

No positions in stocks mentioned.

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