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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.
What happens, though, if loans and securities held by banks start to go bad all at once, as they are doing today? Neither of the two options that Basel II offers is satisfactory. The first one—shrinking the loan book—would be economically destructive, since cutting off credit in today's recession could send businesses and households into bankruptcy. Indeed, Federal Reserve Chairman Ben Bernanke has found in his academic research that a drying up of bank lending was a major factor in the Great Depression of the 1930s.
The second possibility—raising more money from shareholders—is better for the economy but extremely difficult in a downturn because no one wants to buy. So some banks will simply be swallowed up by other banks or opportunistic investors. The Washington-based consulting firm Federal Financial Analytics wrote positively about Basel II in a study released last December, but said: "The new rules kick in at a time of major credit-market problems, which will mean a sharp spike in U.S. bank regulatory capital." Said the firm: "Significant amounts of risk-based capital will need to be raised in a hurry, driving a new wave of industry mergers and acquisitions."
"IT'S PRETTY SCARY"
It's still too soon to see any constrictive effect of Basel II. Most European countries did not put the rule into effect until Jan. 1. And housing and mortgage markets are still holding up pretty well in most of Europe, notes Jon Peace, a banking analyst for Lehman Brothers (LEH) in London. As for the U.S., where the housing slump and the credit crunch are further along, Basel II won't start to be phased in until 2009.
If the credit crunch gets bad enough, regulators are likely to ease up on enforcement of Basel II's capital rules. But that might not happen until some real economic damage is done. "This cycle is going to turn out to be much more severe than the banks ever expected," says Christopher Whalen, co-founder of Institutional Risk Analytics, a Torrance (Calif.) firm that analyzes bank balance sheets. "When you start scoring the risk of this stuff using the Basel II framework, it's pretty scary."
How did we get to the point where an accord that's supposed to avoid trouble could potentially make it worse? To understand that, you have to go back to the predecessor accord, Basel I, which financial regulators devised in 1988 to get banks around the world to beef up their capital. It more or less did its job: Unsafe banks got safer. "It was a rough-and-ready thing," recalls Paul Volcker, who as chairman of the Federal Reserve until 1987 was instrumental in banging the compromise together.
But banks soon learned how to game the system. To avoid having to tie up capital supporting the mortgage loans they made, the banks got those loans off their books by securitizing them. In fact, Basel I was a prime mover in the staggering growth of the mortgage-backed securities market. BaselI didn't require capital backing for lines of credit as long as they lasted less than a year, so banks responded by issuing short-term lines of credit that they rolled over every 364 days.
Alarmed by the "Asian contagion" financial crisis of 1997-98 and tired of being manipulated by the banks, the Basel Committee on Banking Supervision announced in 1999 that it was taking another stab at the problem. The idea was to align the banks' capital more closely with their actual risks, in the process taking away some of the loopholes that let them hold less capital than they really needed. The biggest banks would be required to use their own computerized models to estimate the probability of default on each loan on their books, in keeping with the notion that no one knows a bank's vulnerabilities better than its own managers.
Up until the past year, loan default rates were exceptionally low, so the backward-looking Basel II rules indicated that banks had more than enough capital. That worried U.S. bank examiners, who didn't want banks to shrink their capital cushions in case conditions got worse. 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.
THE 20% SOLUTION
In contrast to the near-term confusion, there is a simple notion for the long term that just might take care of most of Basel II's problems in one swoop. It could be put in place whenever this credit crunch finally ends. The concept is to require the banks to build extremely thick capital cushions that could protect against a multitude of sins and obviate the need for some of Basel II's micromanagement. With sufficient padding, banks wouldn't need to reduce lending during a recession because they would have plenty of capital on hand to keep them safe even if the riskiness of their portfolios increased. In an interview with BusinessWeek, Charles Calomiris, a finance professor at the Columbia University Graduate School of Business, put forward the idea of giving the banks a decade to sell more shares in stages and gradually raise their total capital to perhaps 20% or even 25% of risk-adjusted assets, up from the current Basel standard of 8%.
True, if banks had anything close to 20% capital cushions, their return on equity would be much lower, but so would their risk to shareholders. Calomiris notes that one of the key principles of modern finance is that leveraging up to juice profits, as banks do now, does nothing to improve risk-adjusted returns. Plus, requiring banks to hold much more capital would benefit society by lessening the need for taxpayer bailouts as well as reducing unemployment and other social ills that result from credit crunches. Says Calomiris: "I think the bankers have pulled an incredible game on everybody by making them think that an 8% capital ratio is sufficient."
Calomiris' idea is not likely to be popular with bankers. When told of the concept, Pamela Martin, the Risk Management Assn. regulatory affairs director, said: "That's nuts. It's not even funny."
Calomiris realizes, of course, that his idea opens a can of worms. For one thing, it wouldn't be fair to make commercial banks raise their capital ratios without demanding more capital from investment banks and hedge funds, which compete with them using far more leverage. Whatever the merits of his proposal, it's clear that Basel II won't be the last word on capital standards. Who knows? It just might be time for Basel III.
A research paper released on Feb. 29 by four leading economists finds that highly leveraged financial institutions such as banks and hedge funds reduce their lending by $10 or more for every $1 of capital they lose. So losses on mortgages could cause them to cut back their lending by about $900 billion, shaving 1.3 percentage points off the economy's growth rate over the course of a year, say authors David Greenlaw of Morgan Stanley, Jan Hatzius of Goldman Sachs, Anil Kashyap of the University of Chicago Graduate School of Business, and Hyun Song Shin of Princeton University.