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

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While the internationally minded Federal Reserve mainly supported Basel II as written, the domestically focused bank examiners at the FDIC managed to push through some safeguards against undercapitalization. Unlike Europe, the U.S. will retain a crude "leverage ratio" that takes precedence over Basel II if the two measures give different results.

MISSING THE MARK

The wisdom of the FDIC's caution first became apparent last year when British bank Northern Rock suffered a bank run and had to be taken over by the government. In January, 2007, Northern Rock Chief Executive Adam Applegarth had told shareholders that the bank was "on the cusp" of being able to pay out a big special dividend because under Basel II it was carrying more capital than it needed to be safe. It was a striking example of how badly banks can misjudge their own risks—and the danger for regulators of relying too heavily on those judgments.

Basel II shares some of the problems of mark-to-market accounting, which is being blamed for amplifying downward pressure on securities prices. Under mark-to-market, firms have to write down the value of their assets using whatever the current market price is, even if prices are unrealistically low because of market stress. Basel II likewise requires banks to use price and ratings data in estimating the probabilities of default on their loans and securities.

But the people overseeing Basel II say that concerns about aggravating downturns are overstated. Stefan Walter, who is on leave from the Federal Reserve Bank of New York to serve as secretary general of the Basel Committee on Banking Supervision, says the accord has built-in stabilizers. Walter points out that in contrast to mark-to-market rules, Basel II tells banks to estimate the average risk using historical data. That smooths out the ups and downs in how much capital they need. Also, he says, Basel II tells national regulators to use their own judgment in deciding whether banks' capital calculations are reasonable. Tying capital standards to risk is essential even if it doesn't solve every problem, Walter says. Still, he adds, "we will continue to assess whether we have got the right balance here."

Bankers themselves say Basel II, far from being too hands-off, is actually too intrusive. "You want to have regulation aligned with [the] good risk-management practices" that banks are already using, says Pamela Martin, regulatory relations director for the Risk Management Assn., which represents financial institutions.

Although aligning regulation with the way banks already operate certainly makes things easy, Intelligence Capital's Persaud calls it "a serious dereliction of duty" by regulators. Left to their own devices, says Persaud, banks will tend to operate with too little capital because they suffer only a fraction of the total cost to society of a big bust.

Basel II is coming online at a time when politicians and economists are debating every aspect of how to regulate financial institutions. In late March, Treasury Secretary Henry Paulson announced a plan for a sweeping reorganization of financial regulation in the U.S., which would give the Federal Reserve new powers as a regulator of market stability. However, the Paulson plan is mainly a set of general guidelines for reform that may or may not happen, while the Basel II rules are about to have an effect.

Calls for more fundamental change are likely to grow if the credit crunch worsens. Basel II itself is a work in progress: On Apr. 16 the Basel committee said it would toughen capital requirements for exotic derivatives and pay more attention to making sure banks have adequate liquidity to pay their bills when money gets tight.

The Basel rethink isn't over, either. Says Eugene A. Ludwig, who was Comptroller of the Currency during the Clinton Administration and is now CEO of Promontory Financial Group, a Washington-based financial services consulting firm: "The dust has not settled on what the international community will do, let alone the U.S., on Basel II." He estimates it will be "another six months to a year before one can make more confident predictions" about the effects of Basel II and how regulators might modify it.