Basel III: Form, Function, or Failure?

Ali Habhab

Vol. 40 Associate Editor

The Road to Basel I and Beyond

In the 1980s, a spike in the number of bank failures in the United States prompted banking regulators to turn their regulatory crosshairs to bank capital requirements.[1] Prior to what became known as the Savings and Loan crisis, banks and bank-like institutions began engaging in riskier and more complex transactions.[2] This increasing complexity coincided with a fall in capital levels across the industry.[3] Capital acts as a cushion for banks to draw upon in the event of a run on their assets: the higher the capital to asset ratio, the greater the protection in the event of a liquidity crisis. Resolved to address bank failure risk, regulators believed that increasing capital requirements on banks could reduce the likelihood of failure.[4] The solution, however, could not be addressed solely by domestic legislation – an international coordination problem stood in the way of effective reform. Heightened capital requirements require banks to raise more equity to continue lending at the same rate as under the ex-ante capital ratio, increasing the cost of business. This makes harmonization of capital requirements across borders essential: unilaterally tightening capitalization rules would disadvantage the first mover’s financial industry. Investment would flow to countries with looser requirements – the end result would be to concentrate risk, rather than reduce it. Recognizing this coordination problem, the central bank governors of the G-10 convened in Basel in the 1980s to resolve gaps and inequities in national capital regulation.[5] The first agreement, a non-binding framework now known as the Basel I Accords, applied an 8% capital to asset ratio adjusted to account for differences in risk between assets, albeit with only four levels of risk.[6] As a non-binding accord, Basel I was soft law, but the incentives to overcome the coordination problem led to strong adoption in the initial members and in expansion states in the decade to follow.[7] That said, as the moniker “Basel III” suggests, Basel I was not wholly successful. Criticisms of the first framework included that it:

• Allowed banks to “game” the ratio by taking advantage of imprecise risk weights.[8]
• Failed to address the increased concentration of banking industry.[9]
• Was not politically accountable: negotiated by unelected central bankers already somewhat independent of executive control[10]

Recognizing the inadequacy of the Basel Committee’s first attempt, banking regulators returned to Switzerland in the late 1990s to begin the Basel II process.[11] Regulators set out to strengthen the requirements to reduce the risk of gaming and regulatory arbitrage.[12] The new framework eliminated the imprecise risk weight buckets of Basel I, allowing banks to rely on internal risk models and credit rating agencies to calculate their asset risk weight.[13] Initially heralded as the marquee improvements to Basel I, these two changes formed the basis of Basel II’s downfall. The late 2000s economic crisis engulfed financial markets around the globe just as Basel II’s implementation entered full swing. The strain on liquidity in financial markets led to significant bank failures in the Basel countries, leading many to question what the decades of capital requirement development had accomplished to reduce failure risk. Chief among the critiques was that allowing banks to use internal risk models may have incentivized them to produce overly optimistic risk profiles and that credit ratings agencies were not producing accurate credit assessments.[14] And yet despite Basel II’s serious defects, it was hard to conclude whether these issues indeed worsened the crisis or if they had any effect at all. International banking regulators seemed to run into a proverbial whack-a-mole with capital regulation – solving one problem only to find another. Enter Basel III, the third attempt at producing a comprehensive, international capital requirements regime, ideally without the pitfalls of the last two. Basel III: Lessons Learned Post-Crisis The third round of negotiations proceeded with a sense of haste uncharacteristic of its predecessors. Banking regulation was now en vogue; regulators had broad political mandates to institute prudential banking standards. Accordingly, Basel III overhauled the regulatory regime by requiring banks to hold higher quality capital and to reserve cyclical capital buffers in the event of a crisis.[15] The accords also adjusted the internal risk models for more supervised risk assessment and attached enhanced requirements for the most systemically important global banks.[16] In theory, these measures should address many of the problems that doomed the first two frameworks. And yet the Accord’s fundamental relationships with the Basel I and II cannot be ignored: the capital requirement regime is still based on imprecise risk-weights, still allows internal risk models, and still features some reliance on credit ratings.[17] The third attempt at Basel remains in implementation phase and has yet to be tested in a meaningful way, but more than thirty years after the process began, it might be time to ask whether form, not function, is keeping the regime from meeting its objectives. There is no question that the Basel framework is a rather breathtaking accomplishment for soft international law. International banking regulators have been able to move with relatively swift speed to harmonize capital requirements in the name of economic stability and fair competition. Nevertheless, the very process that generates its direct effects might be at fault for its shortcomings. It is a laudable enterprise to seek to overcome the international coordination problem, but it comes at the cost of the kind of narrow tailoring that would address specific domestic concerns: banks are structured differently and engage in different activities from country to country. When political accountability becomes far removed from law-making, specific needs are neglected for general maxims. The post-crisis environment has spawned new approaches to financial regulation on the domestic level. We’ve seen a shift towards firm-based regulation, evidenced by the creation of the Financial Stability Oversight Council (FSOC), which gives regulators a strong hand to control risk at specific institutions.[18] Basel III seems firm to commit to its existing approach, albeit with new tweaks. There is no question that prudential capital requirements can be an effective tool to mitigate the risk of bank failures, and Basel III won’t be the end of this ever-evolving project. Future efforts should recognize the need to balance harmonization with flexibility. Although it may be more difficult to coordinate across borders, a more innovative approach that recognizes the systemic importance of a few large financial institutions may both maintain the Basel consensus and achieve desired risk reduction.

[1] Federal Deposit Insurance Corporation, The Banking Crises of the 1980s and Early 1990s Summary and Implications, in 1 History of the 80s 3, 3-4 (Dec. 1997). [2] See John Summa, From Booms To Bailouts: The Banking Crisis Of The 1980s, Investopedia, https://www.investopedia.com/articles/financial-theory/banking-crisis-1980s.asp  (last visited —2018). [3] Hubert J. Dywer et al., Optimum Capital/Asset Ratios in the Credit Union Industry: A Mangerial Perspective 8 (Lubin Sch. of Bus., Faculty Working Papers, 1999) https://digitalcommons.pace.edu/cgi/viewcontent.cgi?referer=https://www.google.com/&httpsredir=1&article=1010&context=lubinfaculty_workingpapers [4]Arturo Estrella et al., Capital Ratios as Predictors of Bank Failure, 6 FRBNY Econ. Policy Rev. 33, 33 (2000). [5] See Bank For Int’l Settlements, A Brief History of the Basel Committee 1 (2014). [6] Capital Standards for Banks: The Evolving Basel Accord, Fed. Res. Bull., Sept. 2003, at 395, 396. [7] See Roman Grynberg & Sacha Silva, Harmonization without Representation: Small States, the Basel Committee, and the WTO, 34 World Dev. 1223, 1224-5 (2006). [8]See supra note 6, at 396-7. [9] See Id. [10] See Michael S. Barr & Geoffrey P. Miller, Global Administrative Law: The View from Base, 17 Eur. J. Int’l Law. 15, 18-19 (2006). [11] Ranjit Lall, From Failure to Failure: The Politics of International Banking Regulation, 19 Rev. of Int’l Political Econ. 609, 612 (2012). [12] Id. [13] Id. at 620. [14] See Matthew C. Plosser & João A.C. Santos, Banks’ Incentivesa and the Quality of Internal Risk Models 526 (Fed. Reserve Bank of N.Y., Staff Report No. 704, Dec. 1999); See also Narissa Lyngen, Basel III: Dynamics of State Implementation, 53 Harv. Int’l L. J. 519, 526 (2012). [15] Bank For Int’l Settlements, High-Level Summary of Basel III Reforms 1 (2017). [16] Id at 9. [17] Id at 1. [18]Jeremy Kress, The Case Against Activity-Based Financial Regulation, The CLS Blue Sky Blog (Nov. 16, 2017), http://clsbluesky.law.columbia.edu/2017/11/16/the-case-against-activity-based-financial-regulation/. The views expressed in this post represent the views of the post’s author only.