The BaselAccords – meant to protect depositors and the public in general from badbanking practices – exacerbated the downward economic spiral triggered by thefinancial crisis of 2008. Throughout thecrisis, as business confidence evaporated, banks were forced to sell assets andcut lending in order to maintain capitalrequirements stipulated by the Accords. This lending squeeze resulted ina sharp drop in GDP and employment, while the sharp sell-offin assets ensured further declines.
My recent study with Jacopo Carmassi, Time to SetBanking Regulation Right, shows that bypermitting excessive leverage and risk-taking by large international banks –in some cases allowing banks to accumulate total liabilities up to 40, or even50, times their equity capital – the Basel banking rules notonly enabled, but, ironically, intensified the crisis.
After the crisis, world leaders and central bankersoverhauled banking regulations, first and foremostby rectifying the Baselprudential rules. Unfortunately, the new Basel III Accord and the ensuing EU Capital Requirements Directive havefailed to correct the two main shortcomingsof international prudential rules – namely, theirreliance on banks’ risk-management models for the calculation of capitalrequirements, and the lack of supervisoryaccountability.
The latest example highlighting this flaw is Dexia, theBelgian-French banking group that failed in 2011 – just after passing theEuropean Banking Authority’s stress test withflying colors. The stunning opacity ofsolvency ratios encouraged regulators to turn ablind eye to banks’ excessive risk-taking.
The problem is that the Baselcapital rules – whether BaselI, II, or III – are of no help in separating the weak banks from the soundones. Indeed, more often than not, thebanks that failed or had to be rescued in the wake of the 2008 financial crisishad solvency ratios higher than those of banks that remained standing withoutassistance.
Compounding the problem, the diversity in banks’ capitalratios also indicates a dramatic distortion of the international playing field,as increasingly competitive conditions in financial markets have led tonational discretion in applying the rules. Meanwhile, the opacity of capitalindicators has made market discipline impossible to impose.
Thus, large banks are likely to continue to hold toolittle capital and to take excessive risks, raising the prospect of renewed bouts of financial instability. In order toovercome these shortcomings in international banking regulations, threeremedies are needed.
First, capital requirements should be setas a straightforward ratio of common equity to total assets, thereby abandoning allreference to banks’ own risk-management models. The new capital ratioshould be raised to 7-10% of total assets in order to dampen risk-taking bybankers and minimize the real economic impact of large-scale deleveragingfollowing a loss of confidence in the banking system.
Second, new capital ratioswith multiple and decreasing capital thresholds, which triggerincreasingly intrusive corrective action, should serve as the basis for a new system of mandatedsupervisory action. Supervisors should be bound by a presumption thatthey will act. They could argue that action is not necessary in a specificcase, but they would have to do so publicly, thus becoming accountable fortheir inaction. In order to eradicate moral hazard, the system must have aresolution procedure to close banks when their capital falls below a minimumthreshold.
Finally, solvency rulesshould be complemented by an obligation that banks issue a substantial amountof non-collateralized debt – on the order of 100% of their capital – that is convertible into equity. These debentures should be designed to create a strongincentive for bank managers and shareholders to issue equity rather than sufferconversion.
These three measures, if applied to all banks, wouldeliminate the need for special rules governing liquidity or funding (whichwould remain open to supervisory review, but not to binding constraints). Therewould also be no need for special restrictions on banking activities andoperations.
The most remarkable feature of the policy deliberationson prudential banking rules so far has been their delegationto the Basel Committee of Banking Supervisors and the banks themselves, both ofwhich have a vested interest in preserving the existing system. Governments andparliaments have an obligation to launch a thorough review of the Basel rules, and todemand revisions that align them with the public interest.