Kudos to FDIC director Thomas Hoenig for calling Basel III what it is : a costly, ridiculously complex piece of regulation that won’t do much to help avoid the next financial crisis. “Basel III introduces a leverage ratio and raises the minimum risk-weighted capital ratios,” he told an American Banker regulatory conference last week,  “but it does so using highly arcane formulas, suggesting more insight and accuracy than can possibly be achieved.  Where the markets assess, demand, and adjust intrinsic risk weights on a daily basis, regulators using Basel look backwards and never catch up.”

That is exactly right. If the financial panic should have taught regulators anything, it’s that depending on complex models and formulas like the ones Basel III has in mind to manage calamitous risk is a recipe for disaster. Heading into the crisis, remember, the rating agencies relied on such models to justify AAA ratings on doomed subprime CDOs. It didn’t work. Banks relied on them to manage their balance-sheet and credit risk. It didn’t work. Regulators themselves used them to identify problems at the institutions they oversee. That didn’t work, either. 

News flash: no model can accurately assess the sort of tail risk that’s inherent in the kind of panic the global financial system experienced in 2008 and 2009. The models are useless. Worse, regulators themselves can’t resist the temptation to rig the system ahead of time. One of the reasons the EU is enduring a sovereign debt crisis right now is that, in their brilliance, regulators saw fit under Basel II to give sovereign debt a risk-weighting of zero. Zero! No wonder European banks ended up overweighted in the debt. How did that work out? Yet that zero-weighting notwithstanding, the market knew all about the rising risk in the paper. That’s as good an example as you’ll find of, as Hoening put it, regulators using Basel to “look backwards and never catch up.” It didn’t work last time and it won’t work next time.

Hoenig argues that a simpler, more effective (and harder-to-game) measure would be to simply raise minimum capital standards. He would focus on tangible equity to tangible assets and set a minimum of around 10%. Reasonable people can argue about what’s the right measure (Common equity? Tangible common? Total equity?) and the right minimum (7%?, 10%?, 12%?), but Hoenig’s overall approach makes sense. To that I would add that strict liquidity requirements are also crucial.  

Basel III is going to be an enormous burden to the banking industry, especially small banks. Yet it won’t do much to mitigate risk in the system. Tom Hoening is on to something: the plan ought to be scrapped and replaced with something simpler that will actually work.

What do you think? Let me know!