Basel III and the new financial order: Business Standard 3rd August 2010

After every crisis, the tendency has been to firm up the regulatory processes so that the inherent malaise is tackled. But such actions have the potential to slow down the economy, which is why they run the risk of being counterproductive. Contrarians argue that better surveillance rather than new laws is more important and could be the real solution as it helps pre-empt a crisis. Changes in the financial order have been discussed and the so-called

Basel III is the latest in the study book. It is an interesting development that adds fresh dimensions to an existing issue, and it will come up for further discussion this November when the G-20 meets. Basel II is still incomplete and we are going to Basel III, which is based more on the wisdom of hindsight. What is this new financial order all about?
The genesis of the large-scale failure was in having highly leveraged institutions that were under-capitalised. The talk, therefore, surrounds these twin issues to ensure a stable banking system in future. Four subjects now dominate the discussion. The first is, of course, capital. The thought process involves making capital requirements more stringent so that there are fewer escape routes and this would, therefore, tackle treatment of off-balance sheet items more closely. Further, capital, or rather Tier- 1 capital, is to be redefined as percentage of risk-weighted assets, and there will be some exclusion such as goodwill, minority interest, deferred tax assets, bank investments in its own shares and provisioning shortfalls. All forms of hybrid capital would be phased out. These definitions are to be put in place by 2012.

The second issue is liquidity. Banks need to have adequate liquidity in order to survive a crisis situation. Here, it has been suggested that liquidity should be adequate to survive a stress period of 30 days. But, the issue of what constitutes liquidity remains unanswered as in the current scenario, sovereign bonds, which conventionally were considered good, have come under a bit of a cloud. The suggested guidelines also talk about the matching of liabilities with assets, as banks typically have short-term liabilities that are associated with long-term assets. More long-term funding is the suggestion here.

The third point of debate pertains to taxes and executive pay. The International Monetary Fund (IMF) has suggested a tax on the assets of the banks to build a corpus that can be used at the time of a crisis. This is contentious since while the UK, the US and Germany have gone along with and are considering a 0.04 per cent tax, France and Canada are opposed to this idea. A consensus will develop on the issue in the course of time.

Compensation has been an eyesore in this crisis and there is official talk of not just deferring bonuses, but also devising systems to claw back the bonuses in case of a crisis. Although this sounds good, it may be hard to implement. Several dealers/bankers had taken risks and got good payoffs when the going was good. However, when the crisis unfolded, on account of the risks that had been taken, they could not be made to pay for their actions. It is still not certain as to how this can be done.

The last issue is about making banks safer institutions. Two thoughts have come up here. The first is to have larger banks, which in the past were considered to be too big to fail, to go in for higher capital charges — a kind of surcharge wherein they have to have higher Tier-1 capital. This is an extension of the concept of pro-cyclical buffers, which are built during good times to take care of the rainy days. Simultaneously, there is a demand to build contingent capital which can be converted from debt to equity in times of crisis. The second pertains to assigning higher weights for proprietary trading activities as the attempt is to restructure banking activities into proprietary trading and main banking activity.

While these proposed guidelines would make banking sound, there are some uncomfortable possibilities that may prop up. To begin with, such firm regulation would put brakes on the expansion of bank credit, which can impede growth. Typically, shocks that affect banks’ capital make them adjust to loan supply to meet leverage and capital ratios. The Institute of International Finance (IIF) has estimated that banks will have to raise up to $700 billion of equity and $5,400 billion of wholesale debt between 2010 and 2015 to meet these requirements. This can affect the recovery process in countries that are dependent on bank finance (Europe) as against the ones dependent on capital markets (the US). IMF VaR (value at risk) models suggest that Europe can lose 2 percentage points growth in GDP on this count. Secondly, there is a case of borrowers shifting to the capital market from banks on account of these constraints, which, in turn, can increase the risk factor. The basic justification of intermediation is the ability to bridge the information asymmetry between borrower and lender. With banks being constrained, there would be a shift to the debt market where the perceived risk could be higher. Third, greater recourse to long-term funding to ensure that banks do not have a liquidity squeeze will have a bearing on cost of operations. Finally, the guidelines on proprietary trading and bonuses will have a bearing on financial innovation. While the exotic products did deal a blow to the financial system in the last few years, admittedly, they did bring about substantial re-engineering and churning of funds to sustain the growth process.

The picture is grim as any new regulation runs the risk of clamping down on a sector that has strayed. While such a discussion is in order, Basel III should try not to drive conservatism so hard that it makes banking difficult. Better surveillance instead of over-regulation, it is felt, may just be what should be recommended today. And surprisingly, there isn’t much talk on this subject.