Monday, August 2, 2010

Banking regulation - Basel III update

The sub-prime crisis raised serious questions about the regulatory architecture within which banks and other financial institutions operate. Accordingly, the Basel Committee on Banking Supervision, made up of central bankers and regulators from 27 countries, had initiated discussions last year to "strengthen global capital and liquidity regulations with the goal of promoting a more resilient banking sector".

It has sought to put in place a counter-cyclical macro-prudential regulatory structure for banks that would try to reduce the chances of banking crises and minimize systemic risks if individual banks failed. It is hoped that the Basel II norms on international capital and liquidity requirements and some other related areas of banking supervision would be ready for implementation from 2012.

Any meaningful banking regulation has to work at two dimensions - bank-level (or micro-prudential) and system-wide (or macro-prudential) - and should be counter-cyclical. This is because the nature of modern financial markets, with their complex and opaque financial instruments and massive financial institutions, makes it impossible today to ex-ante assess with reasonable accuracy the extent of damage possible when individual banks run into problems.

Present regulatory architecture suffers many pro-cyclical distortions, where banks tend to accumulate risks when the going is good, only to bear the consequences when crisis strikes suddenly. The discussions to arrive at a new set of Basel III norms have focused on higher capital ratios, use of a leverage ratio as a safety net, tougher risk weightings for trading assets, elimination of softer forms of capital and exclusion of some balance sheet items from capital, higher capital requirements for counter-party credit risks, new liquidity requirements, contingent capital, counter-cyclical capital requirements etc. Fundamentally, effective banking regulation should be designed keeping the following in mind.

1. Banks should have adequate and liquid enough capital buffer, accumulated when the times were good, that could come into use in case of financial market shocks and minimize the public costs of a bailout. Capital reserve requirements (capital as a percentage of risk-weighted assets) are therefore central to any banking regulatory reforms. It adds the important counter-cyclical dimension to the banking system.

Bankers strongly oppose stronger capital buffers on the grounds that it greatly increases banking inter-mediation costs and would adversely affect the ability of banks to make credit available for the non-financial system. They argue that it would limit lending and slow global growth and claim that the economies of the US and Europe would be 3% smaller after five years than if Basel III were not adopted. However, there is increasing evidence to "suggest a much smaller cost that would seem to be considerably outweighed by the safety benefits".

However, capital buffers are meaningless without rules specifying what constitutes capital and the models (with their inherent assumptions) used to measure asset risks. They are the true barometers of the actual amount of capital (liquidity) that are likely to become available for use when crises erupts. The strictest rules would mean little if a very low rate were set, and much higher rates could offset weaker rules on what constitutes capital.

2. There should be clarity on what types of assets constitute capital, so that its liquidity value is preserved. Currently, there are enough dubious assets - deferred tax assets (the money a bank will save on taxes when it earns profits in the future), non-traded stock in a related financial company, mortgage servicing rights (the value of a bank’s rights to collect and pass on mortgage payments) etc - that are hard to monetize in a crisis. The presence of these assets camouflages the real quality of bank balance sheets and makes them appear far more liquid and solvent than they actually are.

3. One of the biggest criticism of the Basel II was the freedom it gave banks to assess trading risks. It permitted the banks to use their own internal risk rating models to determine the risk weightings for their own particular assets, with an idea to align regulatory risk calculations with the considerably more sophisticated risk models that were being used by major banks in their own decision-making. It also permitted banks to use the now highly controversial Value-at-risk (VaR)approach to assess the risk level of trading assets (how far the assets could realistically fall in value before a bank could dispose of the investments).

However, on the flip-side, this flexibility coupled with the perverse incentive structures in the financial markets generated numerous distortions. Often the assumptions that underlay their risk valuation models did not account for the risks posed by complex and illiquid financial instruments like over-the-counter derivatives and credit default swaps. Clarity in risk assessment assumptions and rules, while extremely difficult given the complex nature of modern finance, are necessary to maintain transparency (and therefore minimize information asymmetry problems) and align incentives within the banks.

4. One of the major contributors to amplifying the magnitude of the sub-prime crisis was the massive quantities of leverage banks had accumulated, both on- and off-balance sheets. This excessive leverage not only devastated individual bank balance sheets when the asset markets plunged, they also triggered off a system-wide ripple of risks when these banks started de-leveraging in response to the crisis. This contributory role of leverage highlights attention on the need to contain excessive leveraging during the good times.

5. The deeply inter-connected nature of financial market markets, due to both the nature of instruments and the size of institutions, means that any meaningful assessment of the risks posed by a bank has to take into account both the banks' individual risks and its systemic contribution.

Accordingly, it has been suggested that any measure of counter-cyclical capital buffer should reflect both the pace and accumulation of asset accumulation and the timing and intensity of buffer releases when crisis strikes. Claudio Borio et al favor the credit-to-GDP ratio for the build-up phase and some measure of aggregate losses, possibly combined with indicators of credit conditions, for signaling the beginning of the release phase.

6. Even with the strictest micro-prudential and macro-prudential regulations that address the problems faced by too-big-to-fail and too-interconnected-to-fail banks, the complexity of modern financial markets mean that it may not be possible to effectively limit the effects of fire sales (as banks dump assets to reduce their balance sheets once the crisis erupts) and the resultant credit crunch. As Samuel Hanson, Anil Kashyap and Jeremy Stein write, containing these effects would require going beyond mere capital rules or liquidity regulation. They write,

"While higher capital and liquidity requirements on banks will no doubt help to insulate the banks themselves from the consequences of large shocks, the danger is that, given the intensity of competition in financial services, they will also drive a larger share of intermediation into the shadow-banking realm... increased regulation of the shadow banking sector as a complement to the measures undertaken for banks and other large financial firms. In particular, we reiterate that it would be a good idea to establish regulatory minimum haircut requirements on asset-backed securities, so that any investor who takes a long position in credit assets, irrespective of their identity, cannot do so with an arbitrarily high degree of leverage."

However, even if a comprehensive rule-based regulatory architecture which accounts for all the aforementioned issues is put in place, a highly unlikely eventuality given the stiff opposition both from banking industry and politicians, there will still remain considerable room for regulatory discretion. Therefore, as Senator Christopher Dodd, trying to justify the expanded discretionary power given to regulators to constrain excesses in the financial services industry, said

"We can’t legislate wisdom or passion. We can’t legislate competency. All we can do is create the structures and hope that good people will be appointed who will attract other good people."

Update 1 (11/11/2010)

Excellent article by Simon Johnson which questions some of the opposing arugments to Basel III from the side of bankers. The claim that requiring more equity lowers the banks’ return on equity and increases their overall funding costs reflects a basic fallacy. Using more equity changes how risk and reward are divided between equity holders and debt holders, but does not by itself affect funding costs. High leverage encourages risk taking and any guarantees exacerbate this problem. If banks use significantly more equity funding, there will be less risk-taking at the expense of creditors or governments.

The Basel accords determine required equity levels through a system of risk weights. This system encourages ‘innovations’ to economize on equity, which undermine capital regulation and often add to systemic risk. The proliferation of synthetic AAA securities [around U.S. housing loans] before the crisis is an example.

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