Felix Salmon

Sheila Bair aims her fire squarely at Europe’s banks and their regulators today, contrasting the high degrees of leverage and low degrees of capital in Europe to the safer banks we have here in the US.

The U.S., which has tighter rules governing how FDIC-insured banks determine the riskiness of assets, requires well-capitalized banks to hold capital equal to at least 5% of total assets, regardless of how risky they think the assets are. So for any asset, be it cash, U.S. Treasury securities, or supposedly safe mortgages, banks must hold at least 5% capital against it. European banks do not have this kind of “leverage ratio,” and Basel II has allowed them to treat sovereign debt as having zero risk. That is one of the main reasons they have loaded up on nearly $3 trillion of it…

European regulators should supplement this [9% common equity capital] requirement with the Basel III 3% leverage ratio — or even better, the U.S. 5% requirement, adjusting for accounting differences. The EBA should also use realistic loss estimates more in line with those of the IMF and private analysts. If banks have to accept dilution of their stock or temporary nationalization, so be it…

U.S. regulators made many mistakes, but because we maintained our leverage ratio and delayed Basel II implementation, FDIC-insured banks have remained much more stable than other financial institutions. Bank capital standards should not be an insider’s game. The public deserves better. Bank regulators should do their job, and it is their job, not the job of conflicted bank managers, to set minimum capital levels.

I’m sure that Bair feels that it’s her intrinsic toughness and common sense which resulted in US banks being held to tougher standards than their European counterparts. And she’s absolutely right that when it comes to capital and leverage, US regulators came out of the crisis looking better than European regulators. But not by much. US investment banks were allowed to increase their leverage and decrease their capital as much as they liked — which is one reason why Bear Stearns and Lehman Brothers collapsed so quickly. And other countries, like Canada and India, were much tougher even than the US.

The fact of the matter, however, is that all regulators are captured by banks. Or, to be a little more precise, all legislatures are captured by banks, and all regulators do what the government tells them to do.

In countries like Canada and India, there’s a very small number of strong, well-capitalized banks with a vested interest in maximizing barriers to entry. So they’re happy with very tough standards. In Europe, national banking systems are also concentrated, so in theory they could go the same way. But European banks are more likely to have cross-border and global ambitions, and in any case as a matter of contingent fact they’re not very well capitalized. So they get the regulation they want — which allows them to grow fast without having to raise lots of expensive new equity capital.

And then there’s the US, which is pretty much unique among major economies in having thousands of pretty vibrant small banks. Those small banks have a lot of political clout in Congress, and they hated Basel II, because they’re not nearly sophisticated enough to take advantage of it. So they essentially bullied Congress into keeping the old Basel I standards, for fear that otherwise they would be at a massive competitive disadvantage with respect to the big US banks like JP Morgan Chase. Congress obliged, and used the FDIC as its chosen mechanism for blocking the adoption of Basel II in the US.

Does that make the FDIC particularly virtuous? No: it makes the FDIC just as beholden to the banks as any European regulator. Look at the banks’ contributions to the FDIC insurance fund, for instance: they fell to zero, for no good reason, just because the banks didn’t like making those payments.

So Bair is hopelessly naive if she thinks that European regulators — or even American regulators — can really ever force banks collectively to do something they don’t want to do. The only reason the FDIC has any teeth at all in terms of capital requirements is that it’s in the small banks’ interest, and those small banks have a lot of political influence. There really aren’t any small banks in Europe, and European taxpayers are now on the hook for much bigger potential financial-sector losses as a result. That’s bad for Europe, and the world. But the US, and Bair, are in no particular position to deliver lectures on this subject.

The Clearing House has a new study complaining about the idea that the world’s biggest banks — the Too Big To Fail institutions — should have higher levels of capital than other banks. (The study is meant to be here, but the website isn’t working very well, so I’ve mirrored it here.pdf.) The main conclusion is that “if the Basel Committee’s G-SIB capital surcharge is implemented in the U.S., these banks would have to either increase the borrowing costs to their customers by 60 basis points” — an outcome so self-evidently horrific that the study doesn’t even bother to explain how harmful it would be.

But of course a closer look at the study shows that borrowing costs wouldn’t actually need to rise at all. Here’s the key headline in the presentation:

NIM here, is Net Interest Margin, which is then used to compute borrowing costs. And “NIX ratio” is non-interest expenses, known to many as “bankers’ bonuses”.

The calculations here are not mathematically unconvincing. According to The Clearing House, the cost of bank equity will go down under the new regime — by about 70 basis points. That won’t make up for the hit to shareholders from being less leveraged.

So yes, it’s entirely possible that there is indeed a non-negligible cost to implementing this surcharge. That cost is going to have to be borne by three different groups: borrowers, bankers, and bank shareholders.

But if you look at the report, it’s predicated on the idea that shareholders don’t bear any of the cost at all all: we have to “maintain shareholder returns”, for some unknown reason. This is silly, for reasons convincingly explained by Martin Wolf — the returns that banks are offering to their shareholders are far too high. Back in the 50s and 60s, banks had a return on equity around 7%; now they require more than double that. There’s no reason why we shouldn’t go back to the old returns.

If banks’ return on equity fell from about 15% to about 7%, then there wouldn’t be any increase at all in borrowing costs, and bankers could even keep their bonuses. But more likely, some combination of the three will happen: lower return on equity, lower bonuses, and slightly higher borrowing costs, to the tune of maybe a couple of tenths of a percentage point.

This is all good. Bankers’ bonuses should be lower. And borrowing from a big bank should cost more: it helps to incentivize borrowers to move their business to smaller, less systemically-dangerous institutions.

Besides, the problem right now isn’t that banks are lending at exorbitant rates: it’s that banks aren’t lending at all. I think many small businesses, especially, would be perfectly happy to pay an extra 0.6% if that meant they could get a loan rather than not get a loan.

And it’s undoubtedly true that the more capital banks hold, the less of a risk they pose to the financial system as a whole.

Right now, there are two huge risks which could result in trillion-dollar writedowns at the world’s too-big-to-fail banks. The first is real estate: prices are still falling in the US and around the world, and at some point mortgages can and should have their principal written down. And the second, of course, is developed-world sovereigns, especially on the European periphery. If they default, then there will be a lot of writing down to go around.

Higher capital levels can’t protect us fully against either of those risks, let alone both of them. But they would help. And if banks build up their capital to a healthy point, then maybe we’ll be able to orchestrate a market-friendly set of global writedowns which doesn’t bring the entire financial system to its knees.

Maybe that’s what the big banks really fear, here: that if they’re asked to build up their capital, that only means they’re going to be asked to write down that capital later. I can see why they wouldn’t be happy about doing such a thing. But for the other 99%, the idea frankly looks rather attractive.

Basel has spoken, and the Sifi surcharge — the amount of extra capital that will have to be held by systemically important financial institutions — will range from 1% to 3.5%, with no bank in the first instance being subject to a surcharge of more than 2.5%.

This is more or less in line with expectations, and in fact is maybe a little bit tougher than was expected by some of the pessimists. It’s not the size of the surcharge which is particularly impressive, but more its nature: it’s made up only of the highest-quality capital — no CoCos allowed. And the fact that it’s based on a sliding scale means that it has the important feature of both dissuading the biggest banks from getting bigger and indeed giving them an incentive, at the margin, to get smaller.

The surcharge doesn’t end too big to fail, of course. Bethany McLean is absolutely right that capital requirements aren’t some kind of panacea, and that in and of themselves they don’t prevent crises. But they’re still a crucial part — along with liquidity and leverage constraints, and a crackdown on off-balance-sheet vehicles — of making the global banking system more robust, less pro-cyclical, and less prone to catastrophic failure.

And while the Sifi surcharge won’t stop banks growing to the point at which they have to be bailed out in extremis, it might make such growth significantly less profitable than it was in the past.

One of the peculiarities of the global financial crisis was the behavior of Citigroup’s deposits — here was a huge and insolvent bank, most of whose depositors were not insured. (Citi has many more deposits outside the US than it has domestically.) I was very worried about this: if those depositors moved their money out of an insolvent bank and into something safer, the consequences for Citi could have been disastrous. But the bank run never happened, and in fact over the course of the crisis Citi’s deposit base went up. That’s known as the moral-hazard play: depositors the world over trusted the US government to bail out Citi, as in fact it did, and knew that as a result their money was safe, backstopped by an implicit US government guarantee. Which you certainly can’t say about money held in a foreign branch of a mid-sized community bank.

That’s just one of many advantages to being huge, and as a result it’s great that Basel is forcing the likes of Citi to hold more capital than their smaller counterparts. It might be a relatively small victory, but every win counts.

In the Republican presidential debate last night, there was unanimity on most issues, including the new orthodoxy on the right that bank regulation — like any other regulation, for that matter — is a Bad Thing, and a sign of the government overreaching. It’s important to remember that this is not the way that right-wing parties behave elsewhere in the world. Consider for instance the UK, which seems to be cracking down on banks in a manner which would make even Barney Frank blush:

Britain’s biggest banks will be forced to put a firewall around their retail operations, the chancellor will announce on Wednesday at the Mansion House…

This was the central proposal made by the Independent Commission on Banking (ICB) in its April interim report…

By putting retail banking into a separate legal subsidiary, ring-fenced from the trading and investment banking activities of a big bank, the vital parts of our giant banks will be less exposed to danger in a crisis.

The idea is that the retail banking bits of Barclays, HSBC and Royal Bank of Scotland will have more capital to absorb possible losses…

The ICB’s interim report suggested a minimum capital ratio for retail banks of 10%, which Mr Osborne is understood to support, although he won’t quote any precise number for the new minimum capital ratio.

A source close to the chancellor said there was “nothing sinister” in Mr Osborne’s reluctance to quote a particular number for how much capital above the international floor should be held by British retail banks. “Ten per cent is certainly the right ballpark”, he said.

This is bold and welcome thinking. From a regulatory perspective, banks have good profits and bad profits. Bad profits are the ones coming from risky structured products and leveraged trading desks; good profits are the ones which come from the lending investment capital to individuals, small businesses, and large companies. State-insured deposits should be use to fund good businesses, not risky and speculative businesses — as should any access to central bank liquidity windows.

So if you’re not going to break the big banks up, then the next best thing is to force their riskier arms to operate outside the protective walls of their too-big-to-fail retail operations. And the retail operations should be as bankruptcy-remote as possible, with extremely stringent capital requirements on the order of 10% of total assets.

Now the 10% figure, although it sounds tough, might not be quite as harsh as it seems at first glance: I’m sure that it’s based on risk-weighted assets, for one thing, and so the details of the risk weighting will be very important. And I suspect that banks might be able to put all manner of capital into that 10% bucket, beyond tangible core equity: the UK is likely to allow them to use their beloved CoCos, for starters.

All the same, Britain’s politicians are thinking constructively about how to rein in the more dangerous tendencies of its biggest banks. The same can’t be said, sadly, of their U.S. counterparts. There are bank regulators at the Federal Reserve and elsewhere who are trying to put in place higher capital requirements for systemically important financial institutions — but those will be negotiated on the international stage, in Basel, and will phase in very slowly. The UK policy, by contrast, could simply be implemented unilaterally, and would make that country significantly less prone to systemically-dangerous bank crises. Just don’t think for a minute that it’s likely to be replicated here.

It’s not an easy time to be a central banker. In both the eurozone and the US, unemployment is proving stubbornly immune to monetary policy. And on the regulatory side of things, the global nature of the banking system means that you need to get all major countries on the same page. Which is proving all but impossible, as the latest little spat between EU and US regulators proves.

The FT has all the details, starting with Peter Spiegel’s story yesterday that Michel Barnier, the European commissioner in charge of financial markets, had sent a strongly-worded letter to Tim Geithner, complaining that the US has historically been very slow on adopting Basel standards, and that its attempts to regulate bankers’ pay are toothless and ineffectual. All of this is true.

Today, the FT follows up with the US response, which concentrates on the fact that the US is ahead of Europe on matters such as central clearing and derivatives trading, and hinting that Europe is more likely to backslide on the Basel III timetable than America is. These, too, are reasonable points. Treasury also pushes back on the matter of banker pay, saying it has no real interest in prescribing how much people get paid, just how much risk they’re incentivized to take. That one makes less sense.

This ministerial-level Twitter fight doesn’t, ultimately, make anybody look good. One of the big successes of the Basel III process was that while there were serious disagreements along the way, the governments and central banks concerned were pretty good at keeping the discussions productive and confidential. But just as with Dodd-Frank, it seems, the real difficulty is going to be in implementation, and that’s where there’s a big risk of everything becoming very political.

In the short term, the biggest winners in any fight between regulatory authorities are always going to be the banks, who will happily arbitrage differing regional regulatory regimes and take advantage of their parents’ squabbles to stay out drinking all night. In the long term, however, even the banks would ultimately prefer a single global regulatory regime with clear ground rules and a level playing field — something which lets them concentrate on their main job, of banking, rather than expending enormous effort on lobbying and loopholes.

But with large fractures now emerging even within Europe, and with attention being focused on averting the meltdown of the entire euro project, the chances of a global regulatory consensus seem as far away as ever. Which means that although Basel III is a great idea in theory, the jury’s still out on whether it’s ever going to be consistently implemented in practice.

Well done to Tracy Alloway for calling it as it is, in a post headlined “Citi’s Basel-dodging, capital-avoiding, accounting switch”. At issue is a pool of $12.7 billion in assets, which is housed at Citi’s “bad bank”, Citi Holdings.

In 2008, Citi decided that these assets were not available for sale, and rather were going to be held to maturity. Presto — the bank no longer had to mark the assets to market, and could hold them on its books at par instead. And the difference between par value and market value went straight to Citi’s precious capital, helping it look stronger.

Now, in the wake of a massive bond rally. Citi has decided to switch the assets back. No longer are they held to maturity; instead, they’re available for sale. At a stroke, Citi has to recognize all the gains and losses in the portfolio immediately — that’s $1.7 billion in losses, and $946 million in gains. But the losses can be applied against profits elsewhere in the bank, to reduce the total tax burden. Which is nice, because we wouldn’t want too much money flowing from Citigroup to the taxpayers which bailed it out.

Of course, banks can’t just oscillate back and forth between classifying assets as being held-to-maturity or marked-to-market at whim, depending on how such a classification makes them look in their quarterly report. That defeats the whole point of classing assets as being held to maturity in the first place. If you say an asset is going to be held to maturity, it should be held to maturity, not held to the point at which it’s no longer held to maturity.

And so Citigroup had to explain to regulators what excellent reason it had for changing the classification. And you’re going to love the reason it came up with. The authors of the new Basel III capital adequacy rules, it turns out, managed to notice that assets being held at par and held to maturity are naturally riskier than assets which the bank can sell at any time and is marking to market on a daily basis. And so the capital requirements on held-to-maturity assets are higher than the capital requirements on assets which are marked to market.

So far so reasonable. But Citi’s brainwave was to cite the new Basel III requirements as the fundamental change which would give them an excuse to switch classifications now that the bond market is looking frothy again. Basically, Citi went along to its regulators, and said hey, the capital requirements on these held-to-maturity assets are rather onerous, would you mind if we reclassified them so that we don’t need to hold as much capital against them? And the regulators said by all means, go ahead!

Of course, the assets themselves haven’t changed at all — they’re the same assets, being held at the same bad bank. But now the bad bank has a lower capital requirement, since the assets have been reclassified.

All that remains is to wait until the bond market goes down again, and see what new reason the bright sparks at Citi will be able to come up with to explain that actually, they want to go back to classifying the assets as being held to maturity. It’s all very simple, really: when bond prices are low, assets are held to maturity, and can sit on your balance sheet at par. When bond prices are high, they’re available for sale, and your capital requirements go down. The bank wins either way, while the regulators look like schmucks. And if Citi’s doing this, you can be sure everybody else worked it out long ago.

When the big financial-overhaul bill was working its way through Congress, Treasury persuaded legislators to avoid passing rules on bank capital or liquidity. Leave all that to Basel, they said, so that there could be a global, unified system. And that’s what happened. But if two huge new systems are passed by two highly complex bureaucracies, there are bound to be conflicts. And Melvyn Westlake has a great story in Global Risk Regulator on one of those conflicts: the role of the ratings agencies.

Under Dodd-Frank, the official role of ratings agencies was severely curtailed: regulators are not allowed to use credit ratings when promulgating rules. Under Basel III, however, regulators have to measure the riskiness of bond portfolios somehow, in order to work out how much capital banks should be required to hold against them. Credit ratings are particularly central, under the Basel regime, when it comes to securitizations and measuring both liquidity and counterparty risk.

Squaring this circle, it turns out, is very hard indeed:

“Nobody has put forward any really satisfactory ideas,” admits a Federal Reserve regulator. Already, the absence of a practical alternative to credit ratings has begun to impair new rulemaking in Washington…

The inability to find a solution and the looming deadline is “a source of a great deal of concern,” says Karen Petrou, executive director of Federal Financial Analytics, a Washington consultancy on regulation. “The agencies are informally admitting that they are stumped. But the deadline is only six months away, so something has got to happen. The law is very clear. It says there may be no reference to ratings,” she adds. “We are going to have a hell of a time with the Basel III rules because of the way ratings are still embedded in them,” Petrou reckons…

Finding an alternative to ratings “is not proving an easy task,” confirms Nancy Hunt, associate director for capital markets in the FDIC’s supervision and consumer protection division. “We are looking at several approaches, some more mathematical than others, and trying to backtest them to see if they perform better than rating agencies,” she says. “It’s a very complex and involved process. But we have a law, and we have to figure out how to do this.”

Backtesting is important, of course, but it’s also dangerous: it assumes that the future will be like the past, when the whole point of crises is that they happen when something unprecedented happens. Given the wobbliness of a lot of OECD sovereign debt, for instance, it would surely not be a good idea to put in place a rule which assumes that no OECD debt will ever default or be restructured.

And this, too, is worrisome:

One approach that has been considered by the agencies is using probability of default (PD) and loss given default (LGD) calculations.

I’ve seen that approach before. In fact, I wrote about it at length, in a cover story for Wired entitled “The formula that killed Wall Street.” One would hope that at this point it was discredited.

The alternative, I think, is dumb regulation: just slap conservative risk ratios on pretty much everything, like we did in Basel I, and don’t try to be clever when it comes to measuring risk. That’s just a recipe for regulatory arbitrage. It’s not perfect — dumb regulation never is. But in this case, the perfect is very much the enemy of the good.

Does the Ireland crisis bespeak a major weakness in the Basel capital-adequacy regime? Simon Nixon thinks so: the fact that investors won’t lend to Bank of Ireland, he says, “highlights a major weakness of the Basel capital rules that European banks operate under.”

This is an interesting idea: Ireland’s problem is a banking problem, banking problems are Basel problems, and therefore it stands to reason that Ireland’s problem might be a Basel problem. But if you look more closely at Nixon’s reasoning, his thesis ends up falling apart.

Nixon lays the blame at the feet of Basel’s well-known weakness: the fact that it concentrates on risk-weighted assets rather than total assets. And he implies that there might be large national differences when it comes to the ratio of risk-weighted assets to total assets, while conceding that thesis ” is impossible to prove from regulatory disclosures.”

But there are three huge things missing from Nixon’s piece. First, he takes just one bank from each of four different countries (Santander in Spain, BNP Paribas in France, Barclays in the UK, and Deutsche Bank in Germany) to illustrate national differences. He would be much more interesting, and much more compelling, if he presented a couple more datapoints in each country, to help give readers a better idea of whether French banks in general tend to have a higher ratio of risk-weighted assets to total assets than German banks in general, or whether we’re just looking at idiosyncratic differences between BNP Paribas and Deutsche Bank.

Second, Nixon thinks that the credibility problem in Ireland is a function of the way that the banks’ risk-weighted assets are calculated. He’s right that the market is skeptical that Bank of Ireland really has a core Tier 1 ratio of 8%. And he’s right that risk-weighted assets are a key part of that calculation, and can throw it off. Essentially, the ratio is (A-L)/R, where A is total assets, L is total liabilities, and R is risk-weighted assets. If R is artificially low, then that makes the ratio artificially high.

But the fact is that it’s not the denominator here that the markets are worried about. Instead, it’s the numerator. The key problematic number is A, Bank of Ireland’s total assets. Many of those assets are Irish commercial real-estate loans for which there’s essentially no buyer right now except for the Irish government. And a huge proportion of the rest are Irish residential mortgages, which might be performing for the time being but which would surely sell for much less than par if the bank tried to sell them on the open market.

Any mark-to-market valuation of BoI’s assets, then, would almost certainly show the bank to be insolvent. (This is not news: it’s true of all banks in all crises.) And the reason that the market won’t lend to BoI is that it fears the bank is insolvent. And that has nothing to do with its risk weightings at all: it doesn’t matter what the denominator is, if the numerator is negative.

Finally, Nixon nowhere mentions any Irish ratios of risk-weighted assets to total assets! The very heart of his thesis would seem to be that Basel understated the riskiness of Irish banks by coming up with an unreasonably low number for their risk-weighted assets. Yet Nixon doesn’t tell us what Bank of Ireland’s ratios were, in comparison to those other European banks, and he doesn’t give ratios for any other Irish banks, either.

I suspect this is more than just an oversight. In general, banks reduce their ratio of risk-weighted assets to total assets in one of three ways. They can be heavily involved in investment banking, where loans tend to be taken out in the repo market and are fully collateralized; they can be heavily invested in structured products with triple-A credit ratings; or they can be heavily exposed to OECD sovereign credits. Ireland’s banks, by contrast, were more old-fashioned than that: they just loaded up on property loans, which tend to carry a full risk weighting. There are clearly lots of things wrong with Ireland’s banks, but I doubt that artificially reduced risk weighting was one of them. Certainly Nixon adduces no evidence that it was.

Is Ireland’s problem a Basel problem, then? I don’t think so—or if it is, then we’d need to see a lot more numbers first before Nixon came close to making his case. I understand that the Heard column has space constraints and specializes in short, punchy analysis, but this piece is so short as to be pretty much useless. At the very least, Heard should allow its writers to put extra material online, showing their work, as it were, to back up the conclusions in the printed paper.

In the UK, it seems, the revolving door from big private banks into a grandee’s public-sector role doesn’t turn quite as smoothly as it does in the U.S. And so sometimes it needs a not-so-gentle shove:

John Varley, Barclays’ chief executive, has broken ranks with the rest of the global banking industry, arguing that the availability of credit should be unaffected by tough new capital rules for banks, which he regards as fair.

He praised both the “substance and timetable” of the Basel III proposals in an interview with the Financial Times, in comments that contrast starkly with other senior bankers…

Mr Varley’s stance is particularly surprising because Barclays is among the hardest hit of Europe’s banks by the Basel III changes to regulatory capital…

Mr Varley’s comments will fuel predictions that when he leaves Barclays, he will seek a significant role outside banking.

He has been linked, by those who know him, with possible roles at the Bank of England, in government or as chairman of a blue-chip company. To make the transition from lambasted banker to a role in public service or the broader corporate world Mr Varley needs a softer image, these people say.

There’s no doubt that if any bank will lend less as a result of Basel III, it’s Barclays: not only is it too big to fail, but it’s also more highly leveraged than most of its peers. Its risk-weighted assets are likely to rise substantially under Basel III rules and its capital commensurately.

Which means that Varley’s comments can be taken one of three ways.

Either Varley is right, in which case the Institute of International Finance and the banking lobby generally are wrong and are being unnecessarily alarmist.

Alternatively, Varley is wrong and is making these noises in a nakedly political attempt to ingratiate himself with public-sector technocrats.

Or nobody really knows what the truth is, least of all Varley himself and one’s view of Basel III is fundamentally a function of your job title, or what you’re hoping that your job title will be.

In any event, it would have been nice if Varley had made these noises back when he wasn’t a lame duck, when he actually had influence in the IIF and among banking-industry lobbyists. One thing you can be sure of: at this point, Varley’s views no longer carry any weight in the industry. As such, there’s frankly not much reason to appoint him to a senior position at the central bank.

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.

I’m unapologetically happy and optimistic about the outcome of the Basel III process, and I haven’t been impressed by most of its critics — until now. In two posts, the first at the Economist and the second at The American Scene, Noah Millman does an excellent job of explaining the biggest weakness with Basel III. Which also happens to be the biggest weakness with Basel II.

The problem is that while Basel II was a bold experiment which took a decade to put together and which even then never really got implemented, Basel III was much more of a rush job, and therefore could not be a soup-to-nuts reimagining of what a global macroprudential regulatory regime should look like. Even if that were a good idea.

Instead, Basel III is essentially a bold new layer built over the old Basel II architecture, in much the same way that early versions of Windows were layered on top of DOS. And just as early versions of Windows shared some of the weaknesses of DOS, do has Basel III inherited some of the problems of Basel II.

The main one is the whole concept of risk weighting: the idea that some assets are riskier than others, and that banks should hold more capital against risky assets (unsecured loans to people with a 550 credit rating, say) than they do against much safer assets, like loans to the US government.

That makes a certain amount of sense, but there are two main problems with it. For one thing, it’s backwards-looking: it reckons that the securities which have been risky in the past are the same as the securities which will be risky in the future. That obviously isn’t true. And secondly, it’s easy to game. Here’s Millman:

The consequence of this Basel II reform was to discourage banks from lending to risky enterprises, and to encourage the accumulation of apparently risk-free assets. This was a primary contributor to the structured finance craze, as securitisation was a way to “manufacture” apparently risk-free assets out of risky pools. What brought banks like Citigroup and Bank of America to their knees wasn’t direct exposure to sub-prime loans, but exposure to triple-A-rated debt backed by pools of such loans, debt which turned out not to be risk-free at all.

Since it did not change this risk-weighting, Basel III effectively doubles down on Basel II. Banks will need to hold more common equity than ever—against their risk-weighted assets. That massively increases the incentive to find low-risk-weight assets with some return, since these assets can be leveraged much more highly than risky assets. Unless I’ve missed something, lending to AA-rated sovereigns still carries a risk-weight of zero. So one result of Basel III could be to encourage banks to increase their lending to sovereigns at the margins of zero-risk-weight status. If that happens, anyone want to guess where the next crisis will crop up?

This is all absolutely true, but at the same time a sovereign default is always going to cause a banking crisis, no matter what kind of capital-adequacy rules are in place. Central banks can’t protect banks from sovereign default, and neither can banks themselves. If you’re a bank and the country you’re based in goes bust, then you’re going to go bust too.

But Millman’s broader point is spot-on:

Since taking any additional measurable risk is now stigmatized, the game becomes how to increase returns without increasing measurable risk…

Developments in banking regulation in the last decade, meanwhile, have turbocharged this process, and I’m increasingly convinced contributed mightily to the financial crisis. At the heart of the financial crisis, after all, was banks investing in highly-rated debt backed by lousy mortgages. But why did they hold so much of this debt? In part because they could plausibly argue that it was risk-free or nearly risk-free… If the exposure was classified as market risk rather than credit risk, the Basel II framework was based on Value-at-Risk, which showed very low volatility.

The big-picture point to take home is: the regulatory framework recommended by Basel II assumes that banks are in the best position to measure their own risks, and that a regulatory framework that aligns regulatory capital requirements with the risk being taken is to be desired. In other words, the regulatory framework was pushing banks hard in the direction they were already going: towards avoiding measurable risks and hence (since you still have to make money) into risks you can’t easily measure (or don’t know exist).

As Joe Nocera explains, the whole Value-at-Risk structure gives banks every incentive to push risk into the tails. And because tail risk can be ignored, banks then go on to embrace other mechanisms — like the Gaussian Copula Function — which essentially fatten the tails, stuffing them with ever more risk. There’s not much in Basel III which directly addresses this problem.

And there’s another weakness in Basel III, too. I was at a Manhattan Institute event this evening, at which Paul Singer of Elliott Associates stood up and declared that the big systemic losses which resulted from the bankruptcy of Lehman Brothers were not actually a function of any kind of monster hole in Lehman’s balance sheet. Instead, after Lehman declared bankruptcy, its enormous derivatives book needed to be unwound very quickly, and it was that unwind which caused something between $50 billion and $75 billion of losses, precipitating the worst months of the crisis.

Singer wasn’t saying that the derivatives book caused Lehman’s collapse — far from it. The book was actually pretty kosher. The cause of Lehman’s collapse was liquidity problems, and Basel III does a pretty good job tightening up the rules on bank liquidity. But if a bank with a big derivatives book does end up declaring bankruptcy, the effects can still be catastrophic. Again, that’s not something that can readily be addressed in the Basel III architecture — it requires instead a lot of detailed tinkering with bankruptcy laws. Still, the tail risk remains.

Ultimately, Basel III does a good job of reducing foreseeable risks, and, like any ex ante regulatory structure, it does a bad job of reducing unforeseeable risks. The problem is that as a result, banks are incentivized to load up on the kind of securities which can blow up in unforeseeable ways. I’m not sure that’s something that the Basel Committee could ever really address, but it’s worth remembering, all the same.

All the headlines about Basel III have concentrated on the new core Tier 1 capital requirements — the amount of pure equity and retained earnings that banks are going to have to have going forward. It was banks’ core equity which proved woefully insufficient during the crisis — hardly a surprise, when the Basel II requirement for it was just 2% — and it’s core equity which has seen the biggest beefing up under Basel III, all the way to 7%.

But Melvyn Westlake reckons that there might be a bigger story here in the total capital requirements under Basel III, including not only core Tier 1 capital but everything, up to and including Tier 2. Westlake knows what he’s talking about: he works for Global Risk Regulator magazine, the trade journal which covers all these issues in enormous detail on a permanent basis. Here’s what he just sent me via email:

I would suggest that the Basel Committee intends that Tier 2 capital will have a much more significant role than in the past. It is not absolutely clear what instruments will qualify for Tier 2 in the future, but they will certainly have to be loss absorbing, possibly in a “going concern” situation as well as a “gone concern” situation.

He also notes what the Basel Committee itself has said:

During the recent financial crisis a number of distressed banks were rescued by the public sector injecting funds in the form of common equity and other forms of Tier 1 capital. This had the effect of supporting not only depositors but also the investors in regulatory capital instruments. Consequently, Tier 2 capital instruments (mainly subordinated debt), and in some cases non-common Tier 1 instruments, did not absorb losses incurred by certain large internationally-active banks that would have failed had the public sector not provided support.

It’s going to take a while (something over a decade, most likely) to fully make the switch from the current grab-bag of instruments which count as Tier 2 capital to a much safer system where holders of Tier 2 capital can and will take losses in the event that a bank comes close to failing. So far, the market in contingent convertible securities is nascent at best, and no one really understands how or whether it will evolve — maybe banks will find it easier to just issue equity instead.

But in any case, the new Tier 2 capital requirement of 10.5% is an important number: it basically means that if any bank does need a bailout, its subordinated bondholders are going to be the first to do the bailing out, rather than the government. And it should give some reassurance to the people worried about leverage, too. After all, if you calculate leverage ratios using total capital rather than just equity, they’re likely to come down substantially. And that’s without taking into account the new liquidity restrictions. Lehman’s biggest failure was in liquidity management; the new Basel rules will, if they work, stop another Lehman from happening again. The capital rules are aimed not at preventing another Lehman, but rather at shoring up the global commercial-banking system. Which is just as important.

With a full news cycle now having been and gone since the Basel III accord was announced, a few things have come into more focus.

First, there will always be cynics and nay-sayers. Some of them are serious analysts who wanted a higher capital standard. But most are based on some variation on a simple, defeatist theme: “this doesn’t guarantee that there won’t be another crisis, and banks are still able to engage in dangerous behavior, therefore this is useless”. All I can say is that I’m very glad that the world’s central bankers didn’t feel that way and instead worked long and hard to try to put together a new set of standards which really will reduce systemic risk and strengthen the international banking system.

Of course, banking crises are always possible. But anything which reduces their likelihood is a good thing and Basel III reduces the likelihood of a banking crisis much more than all of Dodd-Frank put together.

Which brings me to Robert Peston, who’s upset at the media for not covering Basel more thoroughly. I’m sympathetic: I’m one of the few financial commentators in the mainstream media who, like Peston, has been banging on about this for a while, returning to the subject on a regular basis. And certainly, compared to Dodd-Frank, Basel III has received almost no press at all. But I part ways with Peston here:

There’s been little populist debate about how much capital and liquidity banks ought to hold for our own welfare. We’ve been presented with a fait accompli.

And most would argue that the media hasn’t exactly done a brilliant job in shining a light even on that fait accompli.

You might also ask where our [elected representatives] have been while unelected central bankers and regulators have trampled on territory that they would surely regard as their own, viz the fundamental laws that affect how [our] banks conduct their affairs.

So if you felt there had been something of a democratic failure here, you might have a point.

The way I see it, the Basel committees did a masterful job of depoliticizing the process as much as possible. The agreement is a win for Treasury, but Treasury was clever in not presenting it as such, because a large number of Republicans will automatically oppose anything that Treasury thinks is a good idea. The functionaries in Basel were generally mid-level central bankers, staying out of the spotlight as much as possible and putting together the best deal they could come up with. If politicians and the media had got involved, that might have made the process more democratic, but it would also have made it much more chaotic and quite possibly would have derailed any chance of an agreement at all.

The fact is that democracy simply isn’t the best possible way to construct a coherent regulatory regime for cross-border financial institutions. And the general public has every right not to feel the need to understand the difference between core Tier 1 and Tier 2 capital, or the finer points of how bank assets should be risk-weighted. This is something which central bankers, as a rule, know how to do — and the great news about Basel III was that they were given the freedom to go ahead and do it, while the power of the banking lobby was temporarily muted and in a period when anybody espousing a laissez-faire approach would automatically get laughed out of the room.

The main thing to take away from the Basel III announcement is that banks now need a lot more equity then they ever did in the past. It’s a little bit of a rhetorical stretch to say that the requirement for core equity has gone up from 2 percent to 7 percent, but it’s narrowly true all the same, even if the 2 percent requirement was never a central part of Basel 2 in anything like the way in which the 7 percent is the very heart of Basel III. And although the 7 percent requirement isn’t formally in effect, you can be sure that every bank in the world now feels the need to meet it. In fact, Credit Suisse said in a research note today that 8 percent is now the market standard for banks to be considered adequately capitalized.

Under previous administrations, financial regulations were quietly loosened, with disastrous results: think of the way that the SEC allowed almost unlimited leverage at investment banks in 2004, for instance. This time around, financial regulations are being quietly tightened. That’s a good thing and should definitely count as a signal achievement of the Obama administration. Even if the president himself isn’t going to make a major television address to trumpet it.

Two of the smartest people I’ve met are coming out this morning with an unexpected (to me, at least) criticism of the Basel III rules.

Mohamed El-Erian:

“The phasing-in period for the new capital requirements is surprisingly long, which will add to the skepticism about the robustness of the bank capital enhancement efforts.”

Joe Stiglitz:

“While it’s understandable, given the weaknesses and the failings of the banking system, that one would want to be slow in introducing these increased capital requirements, delay is exposing the public to continued risk. Given the high levels of payouts in bonuses and dividends, it seems a little unconscionable to continue putting the public at risk with an argument that they cannot more rapidly increase their own capital.”

I haven’t been particularly worried about the timetable up until now, mainly because I haven’t seen much evidence that any systemically-important banks are going to take advantage of the long phase-in period to get away with having capital levels lower than the eventual minimum.

Of course, systemically-important banks are going to have an extra too-big-to-fail capital requirement slapped onto them, over and above the minimum requirements laid out yesterday. So it’s just as well that all of them are currently in compliance with the vision that the BIS technocrats have for smaller banks around the world. (Deutsche Bank might not be there today, but it will be once it’s done raising $12 billion in new capital.)

But the big bonuses that Stiglitz is worried about are overwhelmingly paid out by banks which would be compliant with these new Basel III rules even if they were implemented tomorrow. And once a bank is compliant, the market will punish it severely if it slides back during the phase-in period.

It seems to me that when it comes to the big players in the interbank markets, and any bank with a decent-sized capital markets division, the Basel III standards are de facto in place right now; the only exceptions are banks which have already been nationalized. Or am I missing something here?

Basel III has arrived! The official BIS press release is here, with a wealth of information inside it. But they conveniently also supply this table, which gets to the core of the matter:

There’s a lot to unpack and explain here. But the first thing to note is that we’ve moved from a simple “Tier 1 has to be 4%, Tier 2 has to be 8%” to a 3×3 matrix with all manner of different minima. It’s a bit more complicated, but it’s also more intelligent, and should be much more effective as well.

Possibly the most important thing here is the existence of the first column, setting minimum standards for common equity — which is also known as core Tier 1 capital. Such standards did exist in the past, but they were set extremely low, at just 2%, and so were generally ignored. As of now, common equity is the main thing that matters. No more throwing any old garbage into the Tier 1 bucket and calling it capital: the new standards for common equity are significantly tougher than the old standards for Tier 1 capital in total.

The absolute bare minimum for core Tier 1 capital is 4.5%, and the new minimum for Tier 1 capital in general has now been raised to 6%. The minimum for Tier 2 remains at 8%.

But that’s just the beginning. On top of that there’s a “conservation buffer” of another 2.5 percentage points; to a first approximation, any bank you’ve heard of is going to want to be well outside that buffer, because they won’t be able to pay dividends if they don’t have the full buffer in place. If there’s some kind of crisis and they’re forced to write down a lot of bad loans, they can eat into the buffer — but that will bring extra regulatory oversight, and they won’t be able to pay dividends. That’s sensible.

With the conservation buffer, then, banks need 7% common equity, 8.5% Tier 1 capital, and 10.5% Tier 2 capital.

And it doesn’t stop there, either. When credit in an economy is growing faster than the economy itself, a countercyclical capital buffer kicks in, which essentially says that banks need to have more capital in good times. That countercyclical buffer won’t be set by the BIS in Basel; it’ll be left up to national regulators. But you can probably expect the UK, US, and Switzerland to enforce it up to the maximum of 2.5%.

So when the economy’s booming, banks are going to need 9.5% common equity, 11% Tier 1 capital, and 13% Tier 2 capital.

But wait, there’s more! “Systemically important banks should have loss absorbing capacity beyond the standards announced today,” says the BIS — we don’t know what they’re going to announce on that front, but the chances are that when an announcement comes, the biggest banks are going to need significantly more capital than what we’re seeing here.

This is all very welcome stuff. But it neither can nor should be implemented overnight. Instead, there’s a timetable built in to the new capital standards:

This is even more complicated, obviously, than the capital standards themselves. But in a nutshell, the standards start being phased in on January 1, 2013, with a core Tier 1 requirement of 3.5%. That rises to the final 4.5% in 2015. Other parts of the structure take longer, but they’re all phased in by January 1, 2019 — which is more than enough time for the world’s banks to raise any extra capital they might need.

Meanwhile, various dubious things which currently count as Tier 1 or Tier 2 capital but shouldn’t will be phased out even more slowly, over a period of 10 years beginning in 2013.

Other key parts of the Basel III regime, which weren’t announced today, will also come during these years: the liquidity coverage ratio gets introduced in 2015, while the net stable funding ratio arrives in 2018.

The banks aren’t going to take all this lying down, but I’m hoping their reaction is going to be relatively muted. This is a done deal, now, and they just have to live with it. And the banks which embrace the new standards and are proud of exceeding them will ultimately be more successful than those which try to get around them. Indeed, it would be great to see non-bank lenders adopt these standards too, on a voluntary basis. Most shadow banks easily exceed these ratios already, and I’d love to see the ones which don’t slowly wither away.