The new Basel III norms, hammered out earlier this month, are the culmination of a scare built into the regulatory works of global finance by the recent crisis. They take a shot at improving the most critical element of the world’s banking system—its capital adequacy, which acts as a buffer against crises.
According to the new rules, common equity, the core buffer, has to be at 4.5% by 2019. However, dividends cannot be paid out until the common equity is close to 7% (with a capital conservation buffer of 2.5%). Further, reacting to the fact that banks tend to lend recklessly during a boom, regulators are expected to put in place a countercyclical capital buffer of up to 2.5%. Regulators have also topped this off such that systemically important banks are expected to have a further loss absorption capacity. These levels are 2-4% higher than the corresponding levels in Basel II. All included, banks will now need capital buffers of between 10% and 12%.
Fundamentally all this is great, and should truly be seen as a shot across the bows of careless banking.
Rather, it is the politics behind the Basel III agreement which gives rise to concern. That there is strong opposition to any form of regulation is demonstrated by the length of time offered for adherence—the capital requirement will get going at much lower levels in 2013, and will be achieved fully only by 2019. Such a time frame would normally not be acceptable in any other industry. If a regulator had demanded safety enhancement in cars or emission norms for polluting industries, it would be unthinkable for that industry to have a 10-year window to meet those targets. This extended time frame can lead some to doubt how well Basel III will actually be implemented.
Therefore, there is a worry that some elements of the Basel accord, which are recommendatory, will not be implemented. In particular, there is concern about gaming capital requirements, which tend to be in relation to so-called risk-weighted assets of banks. Most readers will recognize that one of the problems with Basel II was the practice of rating risky assets as prime ones, hiding their true risk to give them lower risk weights. It is possible to have lower risk weights for investments that are highly rated by credit raters (recall AAA subprime loans), even though the same can come to grief later.
There is also a chance that regulators across nations will indulge in arbitrage. What makes regulatory arbitrage likely is that several of the large economies could be facing a period of slow growth, and political pressure on regulators will be high. These countries have in the past not demonstrated the same commitment to taking a system-wide view of risk as, say, the Reserve Bank of India has. Faced with slow growth and political pressure, there could be a race between regulators to permit banks in their countries to get away with a Basel III lite version. We saw something similar when European banks were stress-tested not long ago. The stress test was widely recognized as so weak that it was almost impossible for any bank, which had not already failed, to fail the test. Given this culture, one has to watch this space with some scepticism.
In a sense, Basel III is the closest one can get to a formal global resolution to the financial crisis. Two years after the Lehman Brothers collapse, if there has indeed been an endgame to the crisis, then it is through this regulation. Despite all these doubts, Basel III will have, even in its most watered-down version, an immense impact—one that runs into hundreds of billions of dollars of capital that will get sucked out from the system.
The efficient and appropriate use of capital is at the core of modern economics, and a regulatory framework that affects this can have profound effects. While the intent of Basel III could be diluted by regulators, even Basel III lite will pack quite a punch.
Govind Sankaranarayanan is chief financial officer, Tata Capital Ltd. He writes on issues related to governance.
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