The politics of Basel III

By Felix Salmon
April 3, 2010
importance, on the one hand (high) and the amount of reporting going on around it (very little). If you find good stuff on this subject anywhere, do please send it my way; I feel this is one area where the blogosphere can perform a very useful public service in terms of trying to tease out what's going on, and why, and what kind of effect it's ever going to have.

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It’s long past time, I think, to introduce a Basel III tag on this blog, since in terms of financial regulation it’s clearly the area where there’s the biggest gap between its importance, on the one hand (high) and the amount of reporting going on around it (very little). If you find good stuff on this subject anywhere, do please send it my way; I feel this is one area where the blogosphere can perform a very useful public service in terms of trying to tease out what’s going on, and why, and what kind of effect it’s ever going to have.

One thing I haven’t really seen is a 30,000-foot view of how Basel III Is being put together, so I’m going to take a stab at it. The key thing to note is that it’s basically being driven by national regulators — not just substantially every central bank, but also people like the FSA in the UK and the alphabet soup of regulators in the U.S. (OTS, OCC, FDIC, etc). In this country, it seems that Treasury, and its subsidiaries, are taking the lead in the discussion; Fed officials are more involved in the details, dotting i’s and crossing t’s when it comes to actually drafting highly complex regulations.

Very few of these regulators, it seems unnecessary to say, are on exactly the same page. Many of them think that they’re doing their own jobs perfectly well, thankyouverymuch, and that they neither want nor need to be bigfooted by overarching rules emanating from Basel. Interestingly, this kind of attitude isn’t only found at regulators with a reputation for fighting turf battles aggressively (yes, Sheila Bair, I’m looking at you) — it’s also found in places like the Bank of Canada, which genuinely did do a good job of regulating its country’s banks in the run-up to the crisis, and which is none too excited to implement a far-reaching fix for something which, in Canada’s case, is not obviously broken.

The other hugely important constituency here, of course, is the banks, which are intimately involved in the discussions at all levels. As a general rule, they want as little regulation as possible, and there’s a good chance they’re going to succeed. The small world of top bankers and regulators gets very clubby very quickly — the revolving door has been spinning between the two worlds for decades, and everybody seems to be friends with everybody else.

The relationship between banks and their regulators is crucial. Ultimately, sovereign countries are sovereign, and banks are always going to end up being regulated by a national regulator. Basel just sets the rules, it doesn’t implement or enforce them. And we’ve seen with Basel II in the US that if national regulators don’t like those rules, they’ll just go ahead and ignore them.

Some banks — the French have been mentioned as one example — seem to be perfectly happy for Basel III to go ahead and be extremely strict, because they have their national regulator captured, and are confident that they’ll be given the freedom to ignore the rules they can’t or won’t comply with.

The American banks, while a bit more worried about Basel III than the French, are similarly unlikely to be hit with its full force. For one thing, Basel III is layered on top of Basel II in much the same way that early versions of Windows were layered on top of DOS: it’s really a form of providing Roman reinforcements to the Greek Basel II forces more than it is a whole new capital-adequacy system. To date, the Americans still haven’t adopted Basel II, and there’s no realistic timetable for when they will; unless and until they do, questions surrounding Basel III are pretty moot.

This is where American legislators come in, too. America has many more small, low-tech banks than most other countries, and they’re really not up to the task of complying with Basel II regulations. (Whether the big, high-tech banks can do it is another question entirely.) It’s OK, under Basel II, to grant small banks an exception to the rules, but US legislators don’t like doing that, because they fear — with good reason — that it will give the big banks an unfair advantage over the small banks, since it seems that Basel II banks have more freedom than their Basel I counterparts.

Now it’s possible that once Basel III is layered on top of Basel II, the small banks won’t mind so much about there being a bifurcated set of regulations. It’s possible, but I’m not holding my breath. And there’s a good chance that we’ll have continued pressure from Congress on regulators, telling them not to impose new hardships on their local community banks, or to create an even more uneven playing field between small banks and big ones than there is at the moment.

Meanwhile, the various banks and regulators are all fighting in Basel for their own pet causes. The British regulators want tight controls on liquidity to stop it fleeing a national jurisdiction, as it did not only in the case of Lehman Brothers but also in the case of Bear Stearns; the Japanese banks want to continue to be able to count the value of their internal software towards their levels of capital. (Seriously.) Treasury, as we’ve seen, is worried about US banks ending up at a “competitive disadvantage” to their European competitors.

The banks in general seem to have done a pretty good job of persuading their regulators that there need to be lots and lots of impact studies trying to anticipate what might happen to the global financial system if certain rules were enforced. These studies have a useful delaying effect, of course, and also help to marshall arguments against any big changes. On the other hand, the regulators do seem to have learned one big lesson from Lehman, which is that they have to be able to independently confirm what the banks are saying to them. If a bank says X, the regulatory response these days is “show me”, rather than simply taking the assertion at face value.

The one thing that seems certain is that the negotiations are going to drag on well past the Basel Committee’s self-imposed deadline of end-2012 for implementing the new rules. And it’s also pretty clear that Basel III is the world’s best hope for fundamentally reforming the amount of systemic risk that can be buried inside the global financial system. But whether it’s ever going to get implemented by regulators around the world in anything like its present form is very far from clear.

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