Why Basel III Is Not Enough

Now that summer is over and I have recovered from the shock of Dodd-Frank, we have Basel III on the horizon. Basel III moves in some predictable directions, but — focusing exclusively on capital – still falls short of meaningful reform that addresses the propensity for future crises.

More capital is great. But as many commented almost immediately after release, more capital does not really matter at failure. The reason is that by the time of failure, capital has been required to be held on positions that are usually not the root cause of distress. In the current crisis, that was the off-balance sheet positions spawned by all manner of securitizations and related technology. While Basel III attempts to take some of that better into account, those are only attempts at fighting the last war.

What is needed is a market surveillance approach to identify evolving risks. Of course, the Financial Stability Oversight Board is supposed to be responsible for such surveillance, but because its mandate is couched in terms of “systemic risk” (which remains undefined) prevention, it remains unclear what direction this body will take.

Moreover, the FSOB and other regulators – including Basel – a have been done a disservice by Basel III’s higher capital charges. How so? Capital is costly. When banks are required to incur higher costs, they will spend more energy seeking says to avoid those costs. Hence, we can expect banks to expend MORE energy on capital arbitrage strategies in coming years than they have in the past. With past successes in the realm of securitization and other off-balance sheet technologies, we can rest assured they will come up with more powerful (and contorted) constructs to meet their needs in a higher-capital environment. Moreover, the additional holding company complexity contributed by Frank-Dodd will help hide the risk even more thoroughly than before, actually increasing the propensity for future crises.

The problem will not go away without major governance changes in examination authorities. Presently, exams can be challenged by bankers in myriad ways that are handled on a largely ad hoc basis. Sure, there are some basic procedures for filing grievances against examiners. But there is not a structured “judicial” type system and therefore appeals can drag on forever. As a result, there are two possible outcomes: (1) the bank challenges the regulator in court and is effectively dead long before the case gets to trial, or (2) the bank challenges the regulator directly and buys time to undertake a “bid for resurrection” that increases losses to the deposit insurer and

In summary, we need to re-think both the philosophy and enforcement mechanism of regulation. So far, little deep thought has come about that will reshape our financial services sector and reduce either systemic risk or the regulatory arbitrage or market dynamics that contributed to the crisis. That’s okay. Until we change, we will have ample additional opportunities to get it right.