Inside Financial Services

Let’s Give Basel III The Boot

It's too complex--and won't do what it's designed to do.

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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!

11 Responses to “Let’s Give Basel III The Boot”

  1. Doug Hajek

    I agree with you and with Mr. Hoenig. For further support, I highly recommend all interested persons to read the presentation by Messrs. Haldane and Madouros at the Jackson Hole conference.

  2. CommunityBanker

    Basel III will not only not work, but it will exacerbate bank safety and soundness issues just as it did with Basel II as you point out. For an old-fashioned community bank like us, it will most certainly increase our risk profile.

    The reason for this that we manage interest rate risk (and indirectly credit risk) the old fashioned way – by not being fully lent up and holding a substantial gov’t securities portfolio with a short duration (while our loans are a longer duration). Simple old school banking.

    Now the geniuses with Basel III want to move the market value of those securites in and out of Tier 1 capital. By doing this, they have removed one of the oldest bank strategies around and will force banks to take incremental credit risk as necessary to expand lending and most certainly take on more interest rate risk as short duration securities get replaced by assets of longer duration (and god only knows how long of a duration given the Fed’s actions with respect to interest rates).

    Basel III will make some of the safest banks in the country much less safe.

  3. 2nd Community Banker

    I agree with Community Banker, Tom and Mr. Hoenig. The way I see it, if you cannot explain the essence of a “model” to me in layman’s terms, then it’s probably not good for my bank. A strengthened capital requirement and a sensible liquidity requirement? Now that sounds like an idea that everyone can understand and that all reasonable stakeholders can feel good about!

  4. CommunityBanker

    Basel III will not only not work, but it will exacerbate bank safety and soundness issues just as it did with Basel II as you point out. For an old-fashioned community bank like us, it will most certainly increase our risk profile.

    The reason for this that we manage interest rate risk (and indirectly credit risk) the old fashioned way – by not being fully lent up and holding a substantial gov’t securities portfolio with a short duration (while our loans are a longer duration). Simple old school banking.

    Now the geniuses with Basel III want to move the market value of those securites in and out of Tier 1 capital. By doing this, they have removed one of the oldest bank strategies around and will force banks to take incremental credit risk as necessary to expand lending and most certainly take on more interest rate risk as short duration securities get replaced by assets of longer duration (and god only knows how long of a duration given the Fed’s actions with respect to interest rates).

    Basel III will make some of the safest banks in the country much less safe.

  5. CommunityBanker

    Basel III will not only not work, but it will exacerbate bank safety and soundness issues just as it did with Basel II as you point out. For an old-fashioned community bank like us, it will most certainly increase our risk profile.

    The reason for this that we manage interest rate risk (and indirectly credit risk) the old fashioned way – by not being fully lent up and holding a substantial gov’t securities portfolio with a short duration (while our loans are a longer duration). Simple old school banking.

    Now the geniuses with Basel III want to move the market value of those securites in and out of Tier 1 capital. By doing this, they have removed one of the oldest bank strategies around and will force banks to take incremental credit risk as necessary to expand lending and most certainly take on more interest rate risk as short duration securities get replaced by assets of longer duration (and god only knows how long of a duration given the Fed’s actions with respect to interest rates).

    Basel III will make some of the safest banks in the country much less safe.

  6. MIlton Joseph

    Matt –

    Tom is so much on target with this piece. Although I have suggested a joint effort in the past, I cannot understand why we are not working together.

    Milton
    (845) 642-9109

  7. jsc173

    I find it interesting and ultimately confusing that the Basel III process assumes that the only thing wrong with the controls that were in place a few years ago was that everyone had the wrong model. As you correctly point out, none of them worked because none of them could work. I still firmly believe that sometime around the late 1990′s a new breed of numbers-driven analytic staffs came into this industry – folks with zero banking experience but lots of PhDs in math, operations research and other sometimes very arcane talents – and they analyzed the world and announced they had the answer. They had modeled history and its various business cycles and decided they could quantify both frequency and severity under infinite scenarios. Over time, they continued to validate their models and called them predictive. Yet when the fat lady sang, none of them came close. The worst case scenarios wound up being tame compared to reality. Companies failed, investors were gutted, yet the model builders shrugged, talkrf about “black swans” and generally rationalizing about the outcome versus what they’d predicted. It’s time for a reality check yet no one has yet to step forward and announce no model can predict the future (a/k/a the king is wearing no clothes). It’s as though they can’t say those words for fear the world would come to an end. I’m glad there are people like Hoenig in Washington, but I fear they are in the minority.

  8. Doug Hajek

    I agree with you and with Mr. Hoenig. For further support, I highly recommend all interested persons to read the presentation by Messrs. Haldane and Madouros at the Jackson Hole conference.

  9. cobrapilot 6869

    Does anyone really believe that the regulators that propose these ridiculous attempts to protect our system of finance understand the obvious ramifications of their futile work? The answer is NO. They are bureaucrats hired by bureaucrats. This fact alone dooms them to failure. Unfortunately we all pay the price for their folly. Mr. Hoenig is trying to enter a rigged game with his common sense approach. The bureaucrats will ignore the obvious since it impacts their perception of their value.

  10. Winoramma

    I hear the “The Dog and the Frisbee” speech given at Jackson Hole recently addressed these issues. I’m trying to find the text.

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