Basel regulation needs to be rethought in the age of derivatives, Part II

Adrian Blundell-Wignall, Paul E Atkinson

29 February 2012

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In the ongoing global financial crisis, people are at least acknowledging the need to talk about financial regulation.1 In two Vox columns, we focus on the third edition of recommendations to come from the Bank for International Settlements in Basel (known as Basel III). In our view, Basel III needs serious attention.

In part one (Atkinson and Blundell-Wignall 2012), we argue that the design of the Basel framework for regulating capital adequacy has led to a vast, poorly diversified, highly interconnected banking system supported by far too small a capital base. It has little resilience or capacity to cope with adjustment, so local problems easily become systemic.

How can the system be put on a sounder foundation? By revising and shifting the balance of the three ‘Pillars’ of the Basel system:

  • Drastically simplify Pillar 1 (rules) while making the rules more effective;
  • Be realistic about Pillar 2 (supervision); and
  • Rely more on Pillar 3 (market discipline).

Limit leverage and separate low-risk from high-risk activities

As regards Pillar 1, the risk-weight system for calculating capital charges should be replaced by a simple leverage ratio, ie an upper limit on how many times a bank’s equity (net of any goodwill) can be leveraged. Essential to making this effective is to include gross derivative positions consistent with IFRS2 accounting as part of the asset base requiring equity backing, ie without the netting permitted under GAAP3 reporting and used for purposes of calculating capital charges under existing Basel rules.

Given the size and interconnectedness of the large universal banks, their main activities should be separated from each other in some way to limit the exposure of the entire equity base to heavy losses in any single activity, including trading derivatives. In particular, traditional commercial banking focused on domestic markets needs to be insulated from capital market activities where prices are determined in global markets. In the United States the Glass-Steagall Act (until its repeal in 1999) and the recently passed Volcker rule have aimed to achieve this but at the cost of restricting competition. A better approach is to allow banks to engage in activities as they like but each within a separate subsidiary structure. Each subsidiary should have its own equity base and the full group should be structured as a non-operating holding company (NOHC), along Australian lines or as proposed in the United Kingdom by the Vickers Report, with firm firewalls that subject transfers of cash or other assets between subsidiaries to regulatory approval. This would allow explicit guarantees such as deposit insurance and government-support mechanisms to be confined to certain activities, such as retail banking, without extending them to others, such as derivatives trading. This cannot entirely eliminate a perceived, or implicit, guarantee for such activities. But it would work to eliminate cross-subsidisation by other activities and increase the risk that a subsidiary at least might be allowed to fail. This would force it to stand on its own merits and probably raise the cost of capital to a level appropriately reflecting the risk involved in the activity.

Banks’ are likely to argue against the NOHC proposal on the grounds that it would require inefficient use of capital. Since more capital is desirable, this should be regarded as a powerful argument in its favour.

In contrast, the new Basel III rules relating to liquidity management serve little purpose. A sound capital-adequacy framework and resolution regimes to ensure that problems are addressed while banks are still solvent should suffice to allow bank management to take responsibility for its own liquidity issues.

Be realistic about supervision

As regards Pillar 2, it is important to recognise the limits to what supervisors can achieve. They can enforce sensible rules, insist on honest accounting and transparent reporting, and attack fraud and corruption. They should aim to perform these tasks well. But we should not pretend that they can run banks. The constraints are overwhelming: their resources are too limited to process the information needed to second-guess management of mega-banks; they operate as bureaucrats within a political environment which they must respect; salary differences with the people they are supervising are often stark and invite capture; they are detached from the markets banks are operating in; and while banks will provide whatever information they are asked for, supervisors do not necessarily know what to ask for. Finally, their track record is poor – see for example Northern Rock and the SEC’s Consolidated Supervised Entities programme.

Reduce bank interconnectedness to allow greater market discipline

The effectiveness of Pillar 3 requires a credible willingness to allow large creditors, who provide a much larger fraction of banks’ total funding than do shareholders, to lose money more frequently when they make mistakes.4 The key to this is a reduction in the interconnectedness of the major universal banks and other large players, which results from reliance on wholesale funding and large-scale derivatives trading. This must be brought down to a point where problems do not contaminate under-capitalised counterparties and thereby become systemic. The leverage ratio suggested above would be a good first step in this direction since it would eliminate the existing privileged regulatory status of interbank claims and derivative activity.

But this may not suffice. Since common sense dictates that the authorities will support the system in the event of problems, the large universal banks are widely perceived as too-big-to-fail and benefit from an ‘implicit guarantee’ that is difficult to disavow. As a result these banks enjoy a competitive advantage that works to entrench their position even further. An additional useful step would be to impose a fee, which would have to be agreed internationally, on interbank activity. This would work to increase the cost of such activity and thereby discourage it. In the case of non-derivative funding activities, this could be structured as deposit insurance, with the implicit guarantees becoming explicit and the fee being accumulated in a fund to cover future calls on the guarantee. In the case of derivative activity the fee, which could similarly be used for a fund to insure the financial system, would be tied to the potential full exposure involved in the derivative commitment where a practical basis for measuring this exposure can be devised. Otherwise it would have to be based on transaction values, ie would resemble a Tobin tax.5

References

Acharya, Viral (2011), “Measuring systemic risk and the dismal failure of Basel risk weights”, Vox Talks, interviewed by Viv Davies, 17 June.

Atkinson, Paul E and Adrian Blundell-Wignall (2012), “Basel regulation needs to be rethought in the age of derivatives”, VoxEU.org, 28 February.

Shin, Hyun Song (2011), “Basel III: ‘The only game in town’”, Vox Talks, interviewed by Viv Davies, 25 March.


1 See for instance the Vox Talks (Acharya 2011 and Shin 2011) on this subject.

2 International Financial Reporting Standards

3 Generally Accepted Accountancy Principles

4 As this is written a large package of official support for Greece which will require meaningful losses for many private creditors appears likely to go forward. When the current financial crisis has passed and post-mortems are written, the message these losses send to large creditors engaging in high-risk lending, together with those arising from the earlier bankruptcy of Lehman Brothers, may be seen as a highly positive legacy of the crisis.

5 The financial transactions tax proposed in an EU draft directive is much broader than what is suggested here. It would apply to any financial transaction (except spot foreign currency contracts but including over-the-counter derivatives) undertaken by any financial institution within the EU, irrespective of whether it acts as principal or agent.

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Topics:  International finance

Tags:  financial regulation, BASEL III

Special Advisor to the Secretary-General on Financial Markets; and Deputy Director, Directorate for Financial and Enterprise Affairs, OECD

Senior Research Fellow, Groupe d’Economie Mondiale, Sciences-Po

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