Grading Basel III

By Felix Salmon
October 1, 2010
Alan Blinder's WSJ op-ed on Basel III.

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If you haven’t seen it yet, it’s worth taking a look at Alan Blinder’s WSJ op-ed on Basel III. We’ll get to his conclusions in a minute, but whatever you think of those, he’s done us a great service in clearly laying out the big problems with Basel II that the Basel III needed to address:

  1. Capital requirements were too low;
  2. There was too much reliance on credit ratings;
  3. Banks could use internal models to measure risk;
  4. Banks could get around the rules by setting up off-balance-sheet entities like SIVs;
  5. It lacked any kind of liquidity requirements.

Most of the emphasis and commentary about Basel III has, properly, concentrated on the first of these. Blinder doesn’t like the delayed implementation of the new levels, but that doesn’t bother me so much: as I’ve said before, these ratios are in place already, on a de facto basis.

Blinder also thinks that the backstop leverage ratio of 3% is too low. This gets into the debate between total assets and risk-weighted assets; David Leonhardt asked Tim Geithner about that yesterday at the Washington Ideas Festival. Geithner was clear that as far as he’s concerned, risk-weighted assets are what matters:

What matters is capital against risk. The assets in an institution are not a good measure of risk. What this [Basel III] requires you to hold is 10% of risk-weighted assets. And that’s the right measure.

Well, in the immortal words of Mandy Rice-Davis, he would say that, wouldn’t he. Basel III has been put in place by a group of 27 national governments. All of those governments have to borrow money. They want to ensure that their borrowing costs are as low as possible. And one very effective way of doing that is to ensure that government debt has a very low risk weighting, and that banks don’t need to hold much if any capital against it.

On the other hand, if government debt goes bad, then there’s going to be a banking crisis anyway, no matter what level of capital the banks are holding. Basel capital requirements can try to minimize the likelihood of some kind of banking crises, but they’re not going to be able to prevent a sovereign-debt crisis.

Blinder is quite right, though, that Basel III did nothing to address points 2 and 3, and only partially addressed point 4; that’s a failing.

Finally, there’s the crucial liquidity requirements: after all, the failure of Lehman Brothers was much more a liquidity issue than a solvency issue. The Basel III liquidity requirements still haven’t been nailed down, so we’re going to have to wait and see a bit longer on that front. But significant progress has been made, and banks now have to “to operate with much more conservative funding profiles”, in the words of Geithner — who also pointed out that in the wake of Dodd-Frank, those rules now apply to the shadow banking system as well as to entities which are formally banks.

Blinder concludes with one-handed applause for Basel III; I’ll stick to my two-handed applause, just because politically speaking it’s a very big achievement, and has been put in place very rapidly. Points 1 and 5 are much more important than the others, and those are the areas where the Basel committee concentrated.

I would have loved a mechanism within Basel to be able to revisit points 2 and 3, and maybe point 4 as well. So I don’t really disagree with Blinder on substance. But given how difficult it was to push Dodd-Frank through a single country’s legislature, it’s pretty amazing that 27 countries managed to agree to implement Basel III.

Now let’s keep their feet to the fire in terms of ensuring they actually do so.

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Comments
5 comments so far

I appreciate Felix spending time on this mess.

Basel II was a bad joke. No disclosure, no market discipline. Thus two of the three pillars we explicitly abandoned during the process. Then the regulatory schema of “risk based capital” standards were nothing but a series of linear VaR models stapled together. This entire process was ridiculous from a scientific perspective, yet it is OK for public policy? How can we even have a serious discussion about Basel II/III w/o first admitting that many of the stated goals are simply not possible to measure. If you took this type of methodology to the works of science or technology, they’d laugh you out of the building. And they do. That is why to understand Basel II/III, it must be seen as a political construct first and foremost.

Chris

Posted by rcwhalen | Report as abusive

We boiled the secret to a well-run society down to a single, beautiful rule: Do unto others…

Most of us can’t even get *this* right.

You expect the 27 Stooges to do better?

Posted by Uncle_Billy | Report as abusive

This just shows how little the experts know.

No matter what basic capital requirements is established, a wishy-washy 8 percent in Basel II, or a more real 7 percent in Basel III, when it comes to applying these, you still have to consider the arbitrary risk weights assigned to value the risk exposure created by an asset; like only 20% when lending to anything related to a triple-A rating. And this has not been touched by Basel III.

Since it was the extreme low risk-weights that induced the banks to stampede after lousily rated triple-A rated securities, Basel III is, for all practical purposes, quite close to being a regulatory scam.

Now, with Basel III, as the risk-weight for operations with triple-A rated securities remains 20%, the “more real and solid” equity required is 1.4 percent; and so the new authorized leverage for banks when investing in exactly the same type of securities that set of the current crisis, is 71.4 to 1. Are you really ok with this?

Posted by PerKurowski | Report as abusive

Sampson Iroabuchi Onwuka

I wonder at the chance of induging the commentary and complain of African business men and women. The ex-officio of Central Bank of Nigeria by Charles Soludo, once indicated that Basel II was not useful and very old. There is no where of explaining why it took Basel this long to acknowledge that.

Posted by Onwukairoabuchi | Report as abusive

@adaptivetrader

You seem to have a good handle on credit default swaps and derivatives. I’ve seen estimates of the derivatives market varying from 450 to 650 trillion dollars per year which is many times more than the value of all the assets on the planet.

Do you think it’s possible to safely manage and/or regulate that market?

Does anybody else have any ideas on this?

Posted by breezinthru | Report as abusive
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