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Monday, Sept. 20, 2010


Basel tries to close the cracks

Forget the gnomes of Zurich or the wizards of Wall Street. The real rulers of the banking world are in Basel, and their empire is the Basel Committee on Bank Supervision. From that perch, these individuals develop the regulatory framework that all national bank regulations must work within.

On Sept. 12, the Basel Committee agreed on a new set of rules that are designed to make the global banking industry safer and to prevent the sort of crisis that the world has endured since the collapse of Lehman Brothers in 2008. Ultimately, the success (or failure) of the new regulations will depend on the capacity of national regulators to enforce the standards they establish. Thus far, their record is not encouraging. But after the near calamity of the past couple of years, their thinking may have changed and real enforcement may occur.

While there is disagreement about the causes of the global economic crisis that seized the world in 2008, there is agreement that its impact was magnified by an international financial system that was unprepared for a contagion of this sort. As investigators probed the Great Recession, they discovered that banks were holding risky assets whose values seemed impossible to ascertain — and which had been designed for just that purpose. Those instruments had spread to the point where almost every significant financial institution held some. That meant that as the value of those instruments evaporated, all the banks that held them circled around the drain together.

It was the prospect of a global financial collapse that turned what was "just" the Great Recession into a deeper crisis. While an economic downturn is bad, a financial meltdown, like the one in 2008, is a catastrophe because it threatens the viability of the entire economic system, not just parts of it.

The lesson of the last two years has not been lost on bank regulators. They recognized that banks, and by extension the global financial system, had gotten into trouble by taking on risks far in excess of their reserves, the margin of capital they must hold to protect against losses. Thus the Basel Committee has been working for months to reach a consensus on the appropriate level of reserve requirements that will protect banks.

The agreement they reached more than triples the amount of capital that banks must hold in reserve. The amount of common equity (the least risky form of capital) — the amount of money that shareholders invest in a company's stock as well as profits not paid as dividends — that must be held will be increased from 2 percent to 7 percent. This includes a 2.5 percent "buffer" that banks could draw on in times of crisis. (If they do use that money, they face restrictions on how much they can pay executives or distribute to shareholders as dividends.)

In addition, the committee decided that bank regulators should — rather than "must" — impose an additional "countercyclical buffer" of up to 2.5 percent when there are signs that an economy is overheating. And "systemically important banks," the large institutions that have the capacity to bring down an entire financial system on their own should they collapse, will face additional requirements. The committee has not yet agreed on what those requirements should be. Banks will also be pushed toward more transparency in their trading of obscure financial instruments such as those that brought them to the brink of collapse.

The new rules were greeted with enthusiasm by most bank regulators and even some bankers. Mr. Jean Claude Trichet, president of the European Central Bank and chairman of the Basel Committee, spoke for many bankers when he called the agreements "a fundamental strengthening of global capital standards" that will make a substantial contribution to long-term financial stability and growth.

There were dissenters, of course. Some bankers argued that the new restrictions will reduce their profits, reduce borrowing and slow financial growth. They are probably right. But the sad truth is that lending should be slowed, especially since it was legerdemain, if not outright fraud — and certainly not real wealth — that inflated economic bubbles around the world. Banks were lending money that did not exist. That lending must be curtailed if financial institutions are to be stabilized.

The bite of these regulations has been reduced; the new capital requirements are a compromise. Some regulators wanted larger reserve requirements, which will be phased in over years to ensure that banks are not overburdened.

Ultimately, however, the success of the new regulations will depend on the readiness of national bank regulators to enforce them. Not only has considerable discretion been left in the hands of those authorities — remember, they decide when to impose some buffers and their appropriate level — but they also must enforce the regulations.

In the United States, a deregulatory culture contributed to an "anything goes" mentality among bankers, since they assumed, quite rightly, that banking authorities had neither the will nor the ability to police the industry.

Japan has similar concerns, given the extraordinarily close relationship between bankers and regulators. Hopefully history will spur them to do a better job in the future.

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