How New Global Banking Rules Could Deepen the U.S. Crisis

by Peter Coy

James Victore

In 1999, in the aftermath of a financial crisis that spread from East Asia to Brazil, Russia, and beyond, the central bankers and finance ministers of 10 of the world's wealthiest nations sent their deputies to the tidy Swiss city of Basel. Their mission: to begin devising a set of improved banking regulations for their governments to adopt, with the hope of reducing the harm from future financial crises. The world's leading financial regulators labored together to strike a balance between ensuring banks' safety and giving them room to take risks and make money, finally in 2004 producing a recommended rulebook called Basel II. (Yes, there was a Basel I. More on that later.)

Now, as another financial crisis unfolds, it would seem that nations are adopting BaselII at just the right time. Europe and Japan have put it into practice over the past year, and the U.S. is set to phase in a modified version starting next year. The start date for American banks to begin submitting their plans for compliance to U.S. regulators was Apr. 1.

But despite all the sober and deep thought that went into them, many regulators, academics, and financial analysts are increasingly concerned that the new regulations will end up making today's financial crisis worse rather than better. BaselII is intended to keep banks safe by requiring them to match the size of their capital cushion to the riskiness of their loans and securities. The higher the odds of default, the less they can lend, all else equal.

Here's the problem. Today, many banks already face so many risks that implementing Basel II as written will put them in a capital squeeze. They will either have to reduce risk by cutting back on lending, or sell more shares to give themselves a bigger capital buffer, or both. If the banks do lend less, it could cause an even steeper economic decline, which would lead to more defaults and cause banks to ratchet back even more, and so on in a downward spiral.

In other words, the bureaucratic machinery of Basel II could become a classic case of the law of unintended consequences. "It takes a crisis and makes it worse. I call that a liquidity black hole," says Avinash Persaud, chairman of Intelligence Capital, a London-based financial advisory firm. Adds William I. Isaac, a former chairman of the Federal Deposit Insurance Corp. (FDIC), who is chairman of Secura Group, a Vienna (Va.) bank consultancy: "I'm very concerned about Basel II. I think it will be a serious mistake. It's bad public policy."

Yet the bureaucratic process of creating and implementing the new rules has so much momentum that it will be hard to deflect. Regulators have invested time, money, and their reputations and don't want to be seen as going backward by easing regulation, since it is obvious that overly lax regulation got the financial system into this mess in the first place.

Supporters of the arcane, formula-heavy Basel II accord argue that it's still a step in the right direction because it increases financial oversight and makes sure banks won't be doomed by crises of confidence. The Financial Stability Forum, consisting of the world's most powerful central bankers and financial regulators, insisted as recently as Apr. 7 that as part of the solution to the current financial turmoil, "the Basel II capital framework needs timely implementation."

Basel II has some good points. It's based on the uncontroversial notion that bank shareholders need to have skin in the game, so if there are big losses, shareholders get wiped out before depositors or taxpayers are harmed. Like any company, a bank dies if its assets are worth less than its liabilities. The shareholders' skin in the game is the surplus of a bank's assets, such as the loans it makes and the securities it holds, over its liabilities, such as borrowings from other banks, savings accounts, and certificates of deposit. Basel II says the riskier the loans a bank makes, the more of a buffer shareholders are required to put up.