Basel III – The law re-invented not enforced

Research article written Feb 2012 as part of an application to work at a financial risk market research company. I was proud of it. They liked it; I got the job offer.

Note: It was a short-term role, I am now looking for work, and I’m still proud of this.

 

Bad credit risks made by unregulated credit rating agencies, a burst bubble and a lack of reserve to cover the costs.

This is what Basel III, the Basel Committee on Banking Supervision’s latest set of international regulations finalised on December 16, 2010, is designed to prevent. With wisdom learned from the crisis of 2008, Basel III does have substantial improvements upon Basel II (the regulations in place when the crisis happened) and brand new measures to be implemented completely by 2019.

The changes (and underlying objectives) are clear:

  1. To raise the capital base: Tier 1 capital ratio to be raised (to 4.5% by 2015), Tier 2 capital to be simplified and Tier 3 capital to be eliminated altogether.
  2. To strengthen coverage of capital: To raise capital buffers, promote integrated managing of market and counterparty credit risk, add CVA (credit valuation adjustment) risk, strengthen capital requirements for counterparty credit exposures arising from banks’ derivatives and other transactions. To introduce a new minimum leverage ratio of 3% measure from Basel II) with a Liquidity Coverage Ratio (requiring the bank to hold sufficient quality liquid assets to cover total net cash flows over 30 days) and a Net Stable Funding Ratio (the available amount of stable funding to exceed to required amount over 1 year of stress).
  3. To build capital buffers in good times to draw upon in periods of stress – known as reducing procyclicality and raising countercyclical buffers: Protecting the banking sector from (doing too much with) excess credit growth. The sector would be required to use long term data to estimate probabilities of default and recommendations of downturn loss-given-default estimates in Basel II are now mandatory in Basel III.
  4. To improve risk calibrations (the conversion of loss estimates into regulatory capital requirements): Banks must conduct stress tests – including widening credit spreads in recessionary scenarios, and promote forward-looking practices such as a changing the expected loss (EL) approach.

The most notable, as it addresses the problem of unregulated external credit agencies giving AAA ratings to bad credit risks such as mortgage-backed securities before the crisis, is the requirement for these agencies to be regulated and to change the way loan risk is calculated with more formal scenario analysis lacking from Basel II.

But for all the enthusiasm for new ideas behind Basel III we should take care not to reinvent the wheel. The noble intention behind improving risk calibration is clear – where risks are being taken, we need to improve the calculation. It assumes a stark calculation might provoke more caution – but there is a flawed logic here. For surely the same risk calibration was also the basis of highly rewarding risks. The problem is not the bad calculation or the bad regulation (although regulation can certainly be improved). The problem avoided is why bad risks were taken in the first place – and to prevent any incentives to take such risks again.

I am reminded of Ian Hislop’s comment on why statutory regulation of the press is not needed – the ‘heinous crimes’ brought before the Leveson Inquiry were already illegal. Similarly, bad credit risks were already seen as bad credit risks. We do not need to reinvent the law for people who don’t obey it already.

Furthermore, Robert Jenkins on the Bank of England’s financial policy committee argued in November 2011 that the banking industry has lobbied in a dishonest way since the 2008 crisis. First of all it argued there was no need for change, then, when change was inevitable, it argued reforms needed to be agreed globally – giving until 2019 to acquire the capital needed to meet the Basel regulations. But ‘champagne celebrations’ proved brief when the markets demanded the banks accumulate the capital more quickly.

Mr Jenkins said: “The banking lobby has responded by blaming Basel.”

The banking sector’s protests are worth listening to because it shows us where they will resist change – and where, if they can find a way to adapt Basel III to their advantage, they will take the same risks again.

But the enforcement of penalties or incentives to obey the law that’s already there is what is needed to change the culture, the human nature, of the risk-takers. Then there will be less reason for the banks to take those risks in the first place – and more accountability when they do.

Basel III might be improved simply by listening to a dose of common sense (public opinion). The Guardian’s reader poll in September 2010 asked “Will Basel III prevent another financial crisis?”

87.8% responded with No.

Improving regulations that already exist is only part of the picture.

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