Felix Salmon

Will Basel III really deliver?

By Felix Salmon
September 7, 2010

I very much hope that Die Zeit is right about the Basel III capital requirements: the numbers being mooted there are definitely at the top end of what anybody expected.

They start with a bare minimum Tier 1 capital requirement of 6%; that’s a substantial increase of 50% over the 4% minimum that holds right now. And then they get tougher. There’s also a 3% conservation buffer: essentially, if your Tier 1 capital is less than 9%, you’re constrained in what you can do; certainly you can’t pay out dividends to shareholders. On top of that, the countercyclical capital buffer is being set at another 3%, which means that in good times, healthy banks wanting to pay dividends will need Tier 1 capital of 12%.

Ah, you say, but can’t they just be clever with definitions, including all manner of dodgy-looking assets as part of their Tier 1 capital? Well, yes. So there’s a parallel set of requirements for what they’re calling Core Tier 1: essentially, pure equity. That has a minimum of 5%, plus a conservation buffer of 2.5%, plus a countercyclical capital buffer of another 2.5%.

And there are Tier 2 requirements too. Many of us grew up with the simple rule that Tier 1 capital had to be 4% and Tier 1 plus Tier 2 had to be 8%; the new proposal is a bit more complicated, but you can still add 4% onto whatever Tier 1 number you’re looking at to look at the new requirement for Tier 1 plus Tier 2.

As a result, a healthy bank wanting to pay dividends in a growing economy will need total capital, including Tier 2, of 16%. That’s a reassuringly large number.

The banks are going to scream bloody murder about these numbers, I’m sure, and start waxing apocalyptic about reduced credit availability and lower economic growth and quite possibly plagues of locusts as well. Which is why this paper is so well timed. It’s entitled “Fallacies, Irrelevant Facts, and Myths in the Discussion of Capital Regulation: Why Bank Equity is Not Expensive”, and it finds just that:

The social benefits associated with significantly increased equity requirements are large, while the social costs, if any, are small. Quite simply, bank equity is not expensive from a social perspective, and high leverage is not required in order for banks to perform all their socially valuable functions, including lending, taking deposits and issuing money-like securities.

It will surely take time for the global banking system to get to the kind of capital levels being mooted here; that’s fine. No one’s saying we need to get there overnight. But we should set tough capital requirements now, while there’s some small measure of political will to do so. We won’t get this opportunity again until it’s far too late.

4 comments so far | RSS Comments RSS

Sounds like Springtime for Derivatives Desks… better get that reservation in for the next Ferrari now.

Weird the stuff they are doing about liquidity management is getting zero coverage given that the issue in 2007-2008 was liquidity not capital.

Posted by Danny_Black | Report as abusive

Thanks for linking to that Admati paper, Felix, I had not seen it.

I have to say, though, that while I am broadly sympathetic to the authors’ position (and by extension, to yours), I did not think that their answer to the objection “Increased equity requirements would force banks to cut back on lending and/or other socially valuable activities” was persuasive. They are essentially arguing the flip side of how Modigliani-Miller is usually (mis-)interpreted. And while this has a certain table-turning amusement value, one can be as skeptical of this side of the coin as the other. I think it would be more sound to argue that any net reduction in lending would be worth the gain.

Posted by Greycap | Report as abusive

The report at Banking Day (http://www.bankingday.com/nl06_news_sel ected.php?act=2&stream=1&selkey=10483) says that Tuesday’s meeting wound the Tier 1 number back from 9% to 8%.

Posted by BankingDay | Report as abusive

Felix, you put it very well: “The banks are going to scream bloody murder about these numbers, I’m sure, and start waxing apocalyptic about reduced credit availability and lower economic growth and quite possibly plagues of locusts as well.”

Some banks already do.

I am amazed with the other banks that fool their investors explaining that: “It is not as bad as we were expecting” “We will comply sooner” and my favorite “We already have more capital than required” (failing to disclose that they used the Basel II, not Basel III definition of regulatory capital requirement).

George Lekatis

Posted by GeorgeLekatis | Report as abusive

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