Tuesday, June 15, 2010

Is Basel III “Doomsday” for Banks and Economic Growth?

Sources:
Financial Times: Bankers Warn of Basel III hit to GDP
Financial Times: Bankers’ ‘doomsday scenarios’ under fire
Financial Times: Basel Chief hits back at growth curb claim
Financial Times: Digesting the Basel Reforms
Bloomberg Businessweek: Geithner Meeting Barnier on Basel III Presses Banks
Wall St. J.: G-20 is Nearing Accord on New Capital Rules
Bank for International Settlements: History of the Basel Committee and its Membership

The Basel Committee on Banking Supervision (Basel Committee) sets global banking standards, which national regulators then implement. In 1988, the Basel Committee introduced a measure of capital called the Basel Capital Accord (Basel I) requiring a minimum capital of 8%. In 2004, the Basel Committee issued a revised framework, commonly referred to as Basel II, which refined the standardized rules set forth in the Basel I.
Among other things, Basel II lowered capital requirements and allowed the largest and most sophisticated banks to use internal models to calculate risk of their assets in determining the capital charges against them. Basel II is the minimum standard for international banks and many countries have adopted it in some form.

While Basel II sought to improve on Basel I by aligning regulatory capital requirements more closely to banks’ underlying risk, many have criticized it. In the wake of the global financial crisis, criticism of Basel II has not waned, but has actually increased. In fact, many critics such as Charles Goodhart, a former Bank of England policy maker and professor at the London School of Economics, have gone as far as saying “that Basel II failed.” Therefore, regulators are trying to fix Basel II through a financial reform dubbed “Basel III.”

Basel III will still rely on the banks’ risk models, but will call for tighter control of what goes into the calculations. There will be a narrower definition of what counts as capital and higher capital charges against riskier holdings such as derivatives. Basel III may also impose a cap on the amount of assets a bank can have in relation to its equity. Put simply, Basel III would require banks to keep enough money in reserve to insulate them against future crises. Not surprisingly, these proposed changes have not been without criticism.

As you may surmise, the loudest criticism of Basel III comes from the banking industry. Banks are claiming that the increased capital requirements will significantly reduce their profitability. Moreover, the world’s leading banking industry group has warned that economic growth in the eurozone, the U.S., and Japan will be cut by three percentage points between now and 2015 if the proposed changes come into force. Another group warns that this would lead to 9.7 million fewer jobs in those countries. Thus, according to the banking industry, the combined effects of Basel III will have a disastrous effect on the worldwide economic recovery.

Proponents of Basel III believe that these worries are unwarranted. Banks are assuming the “maximum impact of the maximum change with the minimum behavioral change.” Banks’ business models are not static and can be changed to deal with the new regulations. Furthermore, if Basel III is applied with equal force to all banks, there is no reason why banks could not maintain their profitability by passing the costs of increased capital to their customers without adverse impact on business. However, it is not clear that they would necessarily do so.

Due to the differing views regarding the effects of Basel III, the Basel Committee and the Financial Stability Board have given a mandate to the Bank for International Settlements to assess the economic effects of the Basel III reform. The estimates are still in progress, but the study shows that the costs “aren’t huge” and the “improvements to the resilience of the financial system will not permanently affect growth—except for possibly making it higher.” However, even if the reforms do slow economic growth, many proponents believe that it is a price worth paying for a stable financial system worldwide.

Even though the banking industry contends that the effects of Basel III will be disastrous, it is debatable whether Basel III truly is doomsday for banks and economic growth. Indeed, if there are costs, they may be a small price to pay for global financial stability going forward.

Discussion:
1) If Basel III does reduce banks' profitability, how do you think banks will deal with it (pass it on to customers, find a loophole, more innovation, etc.)?
2) Even if Basel III slows economic growth, do you think it is a price worth paying for a stable financial system?

1 comment:

Musgrave said...

The phrase “economic growth” in this connection is misleading: it implies a reduction in the extent to which an economy expands till the end of time. If there is an effect from once and for all changes (like a change in banking law) it will be a once and for all change in economic expansion in the year in which the change is introduced (and perhaps for the next year or two). But that’s it.

Thereafter, the economy concerned will grow at exactly the same rate it would otherwise have grown at, and that is determined primarily by technological improvements (other things, like labour market efficiency, the efficiency with which the rule of law prevails, etc etc being equal).

Next, I flatly reject the idea (put by banks) that because less lending takes place that therefor the economy contracts.

My basic reason is that banks indulge in “borrow short and lend long” (often called Maturity Transformation) and the recent Basle rules reduce the extent to which banks indulge in this wheeze. Maturity transformation (contrary to popular belief) does not bring benefits, and for reasons I set out here:

http://ralphanomics.blogspot.com/2010/07/brad-delong-is-wong-on-maturity.html

Thus while the Basle rules WILL reduce the total about of borrowing and investment, this will bring BENEFITS for us, not costs. In short, forget all the nonsense about these rules reducing economic growth. They won’t: they’ll increase economic growth (if we have to use the phrase “economic growth”)