Will Basel III Crush the Global Economy?

This week in The Institutional Risk Analyst we feature a comment by Richard Alford on the evolving rules for the new Basel capital framework. Suffice to say that investors and bankers alike need to pay more attention to the machinations in the Swiss city of Basel to develop new bank capital guidelines, standards which could greatly constrict the supply of credit in the industrial nations in coming years.

“It is entirely possible is that institutions will find themselves over the leverage limit even as they remain well capitalized when measured by the risk-based capital metric.”

Richard Alford

“The BIS recently published two documents that bear closer attention from investors and risk managers, especially those who follow financials. The first was a consultative document titled Countercyclical capital buffer proposal. This proposal generated very little industry response, presumably because interested parties were preoccupied with FinReg or were focused on the stress testing of European banks. More recently, the BIS issued a press release that announced a proposed leverage ratio to supplement the new, evolving risk-based capital requirements.”

The countercyclical capital buffer proposal should be of great interest to Americans as it reflects attitudes and perspectives that have not been part of the official U.S. approach to financial stability regulation.

Some of the salient points are presented below. The differences between the proposal and positions recently held by the American authorities suggest that either U.S. influence in the process has become more limited or that the view of the roles of monetary and regulatory policies held by U.S. officials has “evolved” from traditional American positions on bank capital and economic management.

The BIS has also released a proposed leverage ratio to supplement the risk-based capital ratio. In fact, the BIS proposed a 3% leverage ratio, despite the fact that no final decisions have been made on either the measure of capital to be used in the numerator or any adjustments to be made to the denominator –the market value (not risk weighted) of all the assets.

The specific leverage ratio proposed stands in contrast to the capital buffer proposal, which is virtually devoid of specifics.

The mix of great detail and the absence of specifics in the proposals strongly suggest that the decision-making process at the BIS is not so different from the sausage-making process in the U.S. Congress that has resulted in the Dodd-Frank FinReg legislation.

From the BIS Consultative Document:

The countercyclical buffer proposal set out in this document is designed to ensure that banking sector capital requirements take account of the macro-financial environment in which banks operate. It should be viewed as an important internationally consistent instrument in the suite of macroprudential tools at the disposal of national authorities. It should be deployed when excess aggregate credit growth is judged to be associated with a build-up of system-wide risk to ensure the banking system has a buffer of capital to protect it against future potential losses

This (proposed capital buffer regime) should help to reduce the risk of the supply of credit being restrained by regulatory capital requirements that could undermine the performance of the real economy and result in additional credit losses in the banking system.

In addressing the aim of protecting the banking sector from the credit cycle the proposal may also help to lean against the buildup phase of the cycle in the first place. This would occur from the capital buffer acting to raise the cost of credit and therefore dampen its demand, when there is evidence that the stock of credit has grown to excessive levels relative to the benchmarks of past experience. This potential moderating effect on the buildup phase of the credit cycle should be viewed as a positive side benefit rather than the primary aim of the proposal.

As such, the buffer is not meant to be used as an instrument to manage economic cycles or asset prices. Where appropriate those may be best addressed through fiscal, monetary and other public policy actions. It is important that the buffer decisions be taken after an assessment of as much of the relevant prevailing macroeconomic financial and supervisor information as possible and bearing in mind that the operation of the buffer may have implications for the conduct of monetary and fiscal policies.

The differences between recent official U.S. policy positions and elements of the BIS proposal are dramatic.

The Fed has always maintained that monetary and regulatory policies are separate and distinct. The BIS proposal makes it clear that regulatory policy affects GDP and other macro-economic variables and that regulatory policy must be coordinated with monetary and fiscal policy.

The BIS proposal does not assert that regulatory and monetary policies are interchangeable, but does take the position that they can complement or conflict with each other. In the neat world of silos in which U.S. central bankers operate, this is a revolutionary development.

Until the crisis, U.S. monetary policy was guided by the Taylor Rule. There was no provision to adjust any policy based on the growth of any monetary or credit aggregate (except possibly for periods of Quantitative Easing).

The BIS proposal is premised on the idea that an unusually high level of debt relative to GDP is cause to adjust fiscal and monetary policy. In short, the BIS proposal allows a role for credit aggregates in setting monetary policy while Fed policy has not.

The Fed view that interest rates should not be used for financial stability appears to have prevailed. But, has it?

The BIS capital buffer proposal doesn’t call for changes in official rates, but the proposed BIS capital buffer is expected to work by raising the cost of credit, thus dampening the demand for credit much as raising interest rates would.

The Fed, in part, rejected using monetary policy for financial stability on the grounds that monetary policy was too blunt an instrument.

The countercyclical capital requirements also appear to be an equally blunt policy instrument. However, given that the countercyclical capital requirements only affect regulated financial institutions, they will provide an incentive for the emergence of yet another shadow banking system.

There will be additional incentive for market participants to devise and promote institutions and practices that lie just outside the regulatory boundary. Regulated firms will have an increased incentive to practice arbitrage.

It can be argued that the BIS proposal is simultaneously too blunt and not blunt enough.

During the final debate over FinReg, the Administration countered the charge that the law should have imposed capital requirements with the argument that capital requirements were best left to the BIS.

The BIS countercyclical capital proposal does not specify the levels for the buffer requirement. Furthermore, it leaves discretion over when and how to apply the buffer requirement to the national authorities.

A cynic might say that the authorities have found out how to kick the can around in a circle even as they are taking it furter down the road. However, the awkward compromises and omissions in the Dodd-Frank FinReg law suggest that having Congress setting capital requirements may not be such a good idea. Furthermore, the level and structure of future capital requirements will continue to be the subject of much debate.

Here’s my question: Was this BIS proposal adopted over U.S. objection?

The answer is not clear. The proposal was developed with input and comment from 27 central banks and regulators. Many banking systems did not experience a debilitating crisis.

The authorities in those countries may very well be asking: Why should we revamp our banking and regulatory system when we did not experience a crisis and the banking system has contributed to growth?

It is also likely that given the financial crisis and recent economic research citing leverage and credit growth as a cause of the crisis, the Fed position has evolved in the direction of including (at least at times) quantity measures of money (liquidity has already become a focus) in the policy calculus.

Alternatively, the Fed may remain committed to strict inflation-only targeting. The Fed may have agreed to support the proposed countercyclical buffer because it plans on using the embedded discretion, i.e. it has no intention of never employing the capital buffer.

Given the divergence of experiences and world views, it would always be unlikely that an unadulterated US view would prevail. However, the counter-cyclical capital buffer proposal and the European rejection of the U.S. call for more fiscal stimulus together suggest that Washington’s influence over the BIS process has ebbed.

More recently a BIS press release reported that a leverage ratio of 3% will supplement/backstop the risk-based capital requirements.

The specification of the ratio before final decisions have been made about what will be in the numerator (total capital and tangible equity will also be tracked during the trial period) and the denominator is perplexing.

Furthermore the language of the BIS press release implies that after a trial period, offsetting changes will be made in the calibration of the ratio if the measure of exposures (the denominator) is changed: “The assessment will include consideration of whether a wider definition of exposures and an offsetting adjustment in the calibration would better achieve the objectives of the ratio.”

Isn’t this putting the cart before the horse? If changes in the definition of the exposures are to be offset by adjustments in the calibration, it seems that the BIS has already decided that the objectives of the leverage ratio are best achieved with a 3% ratio.

This contrast sharply with the reluctance to specify the parameters of the counter-cyclical capital buffers. On the other hand the testing and phase-in period extends to 2017. This suggests that the BIS recognizes the both the need for banks to adjust and the possible need for adjustment to the leverage ratio.

In addition, the long trial and phase-in periods and other considerations in the BIS document suggest that the global banking authorities expect the leverage ratio to have teeth and be a binding constraint on at least some financial institutions- perhaps including large U.S. institutions.

At first blush, this may appear surprising given that a minimum leverage ratio of 3% implies leverage of 33x — well into Lehman Brothers territory in ternms of leverage. However, given the size of off balance sheet exposures, the inclusion in the denominator of the market value and not the risk adjusted values, it is entirely possible is that institutions will find themselves over the leverage limit even as they remain well capitalized when measured by the risk-based capital metric.

A binding leverage constraint will change behavior.

If the leverage ratio is a binding constraint on financial institutions, it will serve to limit credit extended by affected institutions and the profitability of those institutions even as they the means to evade the regulatory constrain. It is also likely that governments, central banks and regulatory agencies will become more active allocators of capital and credit, especially if economic growth is unsatisfactory.

It seems clear that horse trading is dominating the debate at the BIS over new capital rules much as it has dominated the debate in the U.S. over FinReg.

Perhaps this is the inevitable result of a large group, with varying experiences and world views, trying to reach a consensus. The resulting regulations are unlikely to be elegant or resemble anyone’s first choice.

They are likely to be uncomfortable compromises that leave room for regulatory and cross-border arbitrage as well as possibly requiring or encouraging significant changes in bank business models.

By Richard Alford

You”ll find the original post – The BIS , the Fed and Regulatory Policy Sausage-Making – at the Institutional Risk Analyst home page.


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Filed under International Econnomic Politics, National Economic Politics