In recent weeks, two landmark measures have been approved to address the global financial crisis, Basel III and Dodd-Frank.  There is much to admire about each agreement.  But if their mutual objective of creating a more stable, resilient financial system is to be achieved, additional regulatory measures must be approved and successfully implemented as well. 

The Basel Committee on Banking Supervision pursues its financial stability objectives through a capital adequacy regime.   Basel III is much tougher on capital than Basel I or Basel II, essentially tripling the size of capital reserves that the world’s banks must hold against losses.  Basel III establishes a risk-weighted capital ratio of 4.5 percent.  It also has an additional buffer of 2.5 percent.  Banks whose capital levels fall within this buffer zone will face restrictions on paying bonuses and dividends.  Basel III also strengthens quality of capital requirements.

With its higher capital requirements, Basel III is a big improvement over its predecessors.  However, the impact of Basel III will be muted because it will not be fully implemented until 2019.  Given the frequency with which financial crises, large and small, occur, it is quite possible another financial crisis will have occurred somewhere in the world before Basel III is fully effective.     

The higher capital ratios under Basel III are not enough by themselves to prevent future financial crises.  The potential shortcomings of higher capital requirements are that they could push certain types of financial activity out of the heavily-regulated banking system and into the lightly-regulated shadow banking system.  Thus, the higher capital ratios of Basel III will only help make the financial system more stable if regulators are able to identify and address the emergence of systemic risks elsewhere in the financial system.

The Dodd-Frank Wall Street Reform and Consumer Protection Act addresses a variety of banking and shadow banking issues.  Central provisions of Dodd-Frank include the Volcker rule, early resolution authority, tightened derivatives regulation and the establishment of the Financial Stability Oversight Council and the Office of Financial Research.  The creation of the Financial Stability Oversight Council is an important step toward addressing risks on a system-wide basis.  But given the structure of the FSOC, there are limits on what it can reasonably be expected to do.

While Dodd-Frank’s treatment of selected banking and shadow banking issues is a step in the right direction, Dodd-Frank is also not enough to prevent future financial crises.  Like Basel III, the more stringent requirements of Dodd-Frank could also push certain types of financial activity and risk into the more lightly-regulated shadow banking system.  Thus, it is imperative that regulators be able to identify and address systemic risks outside of the scope of Dodd-Frank and Basel III.

It is difficult to predict how shadow banking activity will evolve in the future.  But there is ample precedent for shadow banking activity helping cause a financial crisis.  For example, in the most recent financial crisis, risks associated with subprime mortgages played a central role in the fall of Lehman Brothers.  Thus, it is very important that regulators have the authority, structure, resources and expertise to monitor and address risks throughout the financial system.

Basel III and Dodd-Frank are key elements in efforts to make the global financial system more robust, stable and resilient.  But the necessary regulatory response does not stop here.  The global financial crisis was caused by a complex mix of issues arising in the banking and shadow banking systems.  Granted, no regulatory regime can prevent all financial crises and a reasonable regulatory balance must be maintained to encourage investment and economic growth.  But if current regulatory efforts are to minimize or prevent future financial crises and help ensure more steady economic growth, they must take a holistic approach and address risks throughout the entire financial system.  The next financial crisis could be lurking in the shadows.