ECON430-Topic #1: Capital Requirements and Basel

Basel, Switzerland is the site of the Bank of International Settlements (BIS) and where the new “Basel Accord” has recently been agreed upon. Increased capital standards in “Basel III” have been opposed by banks, but it appears as though most nations will go along with the proposed changes. While the BIS doesn’t really have the authority to pass banking regulation in any individual country, most countries that agree to Basel III will go along with most of the recommendations. Most of the recommended changes will not go into effect for between 5 and 9 years however, since the current recovery appears weak, and the ability to raise new capital is diminished.

One of the most important recommendations in Basel III is the increase to 7% of capital (WSJ article) required to offset potential losses. Many banks in the U.S. currently hold around 3 or 4% of the value of their assets in what is called “Tier I Capital.” Banks are also going to be expected to create a “countercyclical buffer” of capital which could be used during downturns to offset potential losses. Thus, banks would be required to hold more capital during good times than bad.

Back in May, the Economist published an article about how banks were fighting new regulations thought to be forthcoming in Basel (economist link or wiki link). While the banks might not have gotten everything they wanted, bank stocks generally rose upon the news of the delay in implementation.

Questions you might try to answer:
  • Do you believe that the banks will have any influence on when the “countercyclical trigger” gets pulled based on your insight on changes to the Basel agreement between May and September
  • Do you believe that the economy will suffer either today or in the future because of more stringent capital requirements? Is it worth it to have a future restriction on the growth of global capital? Here you could see an article posted on Bloomberg.
  • How do you believe other countries like China will play into banking when they are not part of the Basel agreements? Do you believe that China’s role will supersede any of the changes?

21 thoughts on “ECON430-Topic #1: Capital Requirements and Basel”

  1. It seems to me that this kind of increased regulation is the price of the deposit insurance that banks now enjoy. Personally, I would support a more laissez faire environment, with the exception of regulations which assure transparency and the full availability of information to customers. However, the current system, by including central bank insurance and the possibility of bailout, creates a situation where banks get full credit for successes while only suffering partial penalties for failures. This system virtually guarantees abuses, or at least unwise dealing. As long as the central banks continue to cushion failures, more regulation is needed. This will obviously hinder a banks ability to maximize its profit, by virtue of the simple fact that it will be able to use less of its capital then before. Giving significant notice, as is being done here, should lessen the impact, but such regulations do restrict a bank’s ability to lend. The only immediate benefits that can offset this are the elimination of uncertainty over what the new regulations will be, and possibly increased consumer confidence as a result of more bank restrictions.

  2. By reading this article, a question comes to mind. What is the cost of the increased regulation? The increased regulation will only raise prices of doing business with a bank and also tighten the standards at which capital can be lent out to the private sector. However, it is in my opinion that even with the regulation the banks will still control when to pull the so called “countercyclical trigger”. This is so because they are going to do everything they can to delay the formation of such a buffer. In saying this I agree with Andrew in that a more laissez-faire approach with the availability of full information would be better for the banking system than such a regulation. This would eventually lead to “proper” lending practices because banking institutions would realize that they did not have someone there to swallow their losses for them.

  3. I want to visit the negative effects that the new capital requirements could immediately have on our economy. I believe these requirements will cause banks to lend less. Since banks would have to hold minimum levels of capital requirements, they would be unwilling to lend as freely as before. With banks lending less to preserve their capital, business growth could become stagnant [1]. This could cause the economy to suffer even more immediately. Over the summer I worked with the Stafford County Department of Economic Development. One of the concerns of many small businesses that I was in contact with was their inability to gain funds in the form of loans and grants for growth or startup purposes.

    Following up on this issue, these new requirements could crowd out smaller banks, even though the capital requirements will not come into effect for some time. Banks that are already suffering from the recession because of defaulted loans and foreclosures are going to find it extremely hard to raise the additional capital needed to fulfill the requirements. With smaller community banks unwilling to loan to these business, they would find it hard to expand which would further hurt job creation [2].

    [1] http://www.economist.com/blogs/newsbook/2010/09/basel_iii
    [2] http://www.thesunnews.com/2010/09/14/1692417/capital-rules-could-set-back-small.html

  4. We are convinced by the fact that banks have better achievements from a self-regulatory system, however, we should bear in mind that burden of financial crises, caused by the improper “self-regulatory” system is not carried by the tax payers and consumers. Tariq Scherer in his blog which is posted on the Economist makes a historical and judgmental argument against the Basel III accord. For him, the capitalization ratio, which is self-regulated and supported by the market, is something crucial which works in real life. Please read his blog for full discussion (link below).

    Nevertheless, personally I think there are two crucial factors in this accord. One is the “countercyclical buffer” which provides banks to create additional support at times of duress. And the second is the “Time” itself. Until when Basel III will be effective fully in 2018, both the banks and the consumers respectively would discipline themselves in thinking twice before deciding which transactions to engage in, of course if the consumers have access to the full information from the market. During these eight years, which can be called a transition period, the banks would behave to take proper risk management measures and the consumers of capital will be doubly cautious in their financial investments. Hence, although it seems that the stringent capital requirements would vigilantly slow the economy, in the long run the economy may emerge stronger and safer.

    Sources I used:
    http://scherer.dyndns-web.com/2010/09/14/an-example-of-market-priced-capitalisation-metrics-the-span-method/#more-822

    http://www.economist.com/node/17027188?story_id=17027188&CFID=147645435&CFTOKEN=16493524

  5. Aside of the typical capital reserve requirements guidelines set by the accord; I would like to raise the issue of regulation on Commercial Paper outlined in Basel III. The new Liquidity Coverage Ratio requires banks to cover all commercial paper credit lines, made to businesses, with short-term liquid assets. To place matters in perspective, commercial paper peaked pre-Lehman with 2.2$ tr. and currently stand at 1.06 tr. corporations high rely on commercial paper to finance their daily operation (2). This new requirements will hit corporations and consumers where it hurts, as banks rev up rates, and as a result business raise prices. Also, it is interesting that the committee has set a 5 years “observational period” (3) to examine the consequences of this ratio requirement, which tell me of their doubt and indecisiveness, or maybe they know something we don’t. In my opinion, regulating CP might be a good idea, but not to this extend.

    Last point I want to bring up is the potential flock of banks to China. While it is common sense banks might divert their operation to a laizze-faire environment, we need to examine the banking framework in China. The Chinese government enforces strict requirements, when it comes to relying their banking operations on foreign banks (1). Banks such as Citi or HSBC with branches in China didn’t shine (1). My opinion is that the growth in China is fast, but not sustainable. When growth slows down, China will relax these foreign banking rules, and then banks will have further incentive to operate in East Asia.

    Sources:
    1)http://online.wsj.com/article/SB10001424052748704652104575493463528923210.html?mod=dist_smartbrief
    2) http://www.cnbc.com/id/39193598
    3) http://www.ft.com/cms/s/0/269cfa5c-bf13-11df-a789-00144feab49a.html
    4) http://www.ft.com/cms/s/0/6c6b672a-be7e-11df-a755-00144feab49a.html

  6. Although increased capital requirements may have a small negative net effect in the short run (business cycle), it will most likely have a long run net positive effect (Economic growth and employment). Banks are warning that the increased requirements will increase the cost of credit for borrowers, resulting in lower economic growth. However, this cost is worth it if increasing the capital requirement will prevent future bailouts funded by taxpayers. There will be less of a moral hazard issue so the banks should focus less on risky assets. The requirements should be attainable since the BIS is phasing them in gradually over the years of 2013-2018 (shown in the last 2 tables in the document below) [1]. These rules must be strictly enforced to be effective. Everyone must play by the same set of rules and the rules must be known and adhered to by all. They must be applied to derivatives as well. In conclusion, increased requirements may be painful at the beginning, but the economy as a whole will be better off without the need to bailout financial institutions.
    http://www.bis.org/press/p100912.pdf?noframes=1

  7. Banking entities need regulations imposed because the current system is not stopping the public tax burden on bail outs. Banks are participating in too many risky investments because of the moral hazard of the FDIC that exists. Although “Perfect Markets” are better off left not tampered with by government activity, it cannot be possible because of all the imperfect information and fowl play that is occurring within the internal system of the financial market. Bank requirements to increase capital will create a new confidence for depositors. Every depositor can feel safer knowing that there is a larger safety net to their savings. There will be more confidence in the government from the decrease of suspiciously large bank bail outs funded by public money. People can also attain more trust in their banking systems. The larger capital requirements will spur a confidence in investing in bank stock because the odds of the bank becoming insolvent will have decreased. Although there will not be as much capital lending, the borrowers will be more qualified to pay back the loans and there will be fewer defaults.

  8. The main problem that I see with the new Basel Accord is that the planned time frame for it to take effect is too long. By continuing to delay this raise of capital along with a buffer, the public is being exposed to an increased risk. The goal of this plan is to lower the risk the public is seeing right now. I see no real problem for banks raising their capital to 7% in two or maybe even three years. Right now this shift in capital holdings would most likely result in banks dropping their level of Tier 1 common equity from 6.5% down to around 4 (H. Rodgin Cohen). This will force banks to ultimately reallocate their assets on a whole, but this will result in a decreased level of risk for the banks as well. If they need to be holding more capital they will be taking less risks with their assets overall.

  9. I would submit that the lassie fair attitude towards self regulation is what got us to this point in the first place. Not only do the capital requirements increase confidence in consumers but during recession the Fed will now have a serious reserve deposit margin to use in monetary policy. The collapse of Lehman Brothers might have been averted had they had more capital (1). The direct result was a crisis that ended in TARP. TARP is and was nothing more than a way to temporarily recapitalize banks in the absence of a willing private party. Secondly if a slightly increased tier-1 capital ratio, five years down the road, is all that happens as a result of government intervention that suppose to cost $109 billion (2) then banks are getting off with less than a slap on the wrist. While in general capital requirements might go up I personally think governments worldwide will impose at the national level, more punitive measures. To answer the questions succinctly; yes politics means banks will always have say, nothing worse for now but less variation and milder downturns in the future, Chinese banks are subject to the whims if the Communist party who is a much less merciful master then a boardroom full of western central bankers.
    1) http://www.thedailybeast.com/blogs-and-stories/2010-09-15/meltdown-anniversary-how-lehman-brothers-triggered-the-aig-bailout-/
    2) http://www.cbo.gov/ftpdocs/112xx/doc11227/03-17-TARP.pdf

  10. I think that Basel III’s increased capital requirements are a step towards a more resilient banking system but are a far cry from fixing the problems of a broken system. One major issue is that banks are still the ones assessing their own assets. During the crisis, one major issue was dishonest banking practices and I do not think Basel III does enough to prevent this. I think that what is needed is more oversight over banks especially if there are these obvious incentives for dishonest banking. These incentives would be things like incentives for high risk practices due to the high profitability and limited liability because of government bailouts. With this kind of thing possible, governments should be watching banks much more closely to make sure that banks not only have this new 7% requirement but also that the capital is strong and valued correctly.

  11. If you examine the exact purpose of the countercyclical buffer it encourages banking institutions to build up their buffer in a time when there is excess aggregate credit growth (1&2). From a 30,000 foot view this seems like a safe, modest, and responsible decision for regulators to implement, but if they give the banks influence over when this “trigger should be pulled,” it will likely lead to moral hazards and conflicts of interest in the economy. This is primarily due to the fact that bank earnings are positively correlated to credit outstanding in the economy. The more money banks lend, the more interest bearing assets they have on their balance sheets. Banks would not want to stop lending as credit expands even though it would be harmful to the overall economy. An interesting question to research further would be how regulators quantify the actual trigger. Are there thresholds and ratios for aggregate credit in the economy?

    (1)http://www.bis.org/publ/bcbs172.pdf
    (2)http://www.reuters.com/article/idUSTRE68B16L20100912

  12. In 2008 when the crisis began, banks were not being regulated nearly enough and maybe if they had the crisis could have been lessened or even avoided. Banks were only required to have a 2% base tier 1 capital, which was not nearly high enough and some banks just didn’t have enough saved up to withstand the crisis. After reading in more detail about Basel III, it seems like an important regulation and one that should be implemented. It increases the minimum common equity requirement from 2% to 4.5% with an additional 2.5% capital conservation buffer to help withstand future times of stress. This require 7% should go a long way to surviving future times of stress and give confidence to current and future depositors. The only problem I have with Basel III is that they are giving banks so long before they have to have this required amount (2015-2019). Also according to the Bloomberg article, there is very little reason it should take that long for banks to meet this required amount, because most banks already can meet the mandatory 7%. Overall Basel III looks helpful and a step in the right direction, but is not all that needs to change.

  13. The new Basel III accord is a positive move in correcting for some of the major issues that expose the public to risk taken on by the banking industry. Unfortunately, the way the agreement has been structured, big banks are being given a slap on the wrist, while small commercial banks will find the new capital requirements straining (1). Many of the largest banks in the U.S are already close to meeting the new capital requirements, while the smaller banks that have been crushed by the recent mortgage crisis are struggling. These increased capital requirements will clearly affect the cost of borrowing for everyone, but small businesses, which traditionally rely on small commercial banks will be hit the hardest. So, while we are looking at a future decline in growth due to an increased cost of capital across the board, the question is whether or not economic recovery will be hindered even more because of how hard local lending will be hit (1). In a study done by the SBA, small businesses were shown to produce almost half of nonfarming GDP between 1998 and 2004. With small businesses accounting for such a large part of our economy, I think that it will be prudent to tailor the application of Basel III during the transition period, so that small banks continue to lend.

    1)http://www.huffingtonpost.com/ellen-brown/basel-iii-tightening-the-_b_719536.html
    2)www.sba.gov/advo/research/rs299tot.pdf

  14. I take the view that the Basel Reform is good, and a step in the right direction. I don’t think that the higher capital requirements will significantly raise interest rates like some people believe will happen. In May many people were expecting the proposed regulation to have a significant impact on the banking industry. However, once the reform was finalized it was much less intrusive than people predicted. In the Bloomberg article a few economist pointed out that raising capital doesn’t have to be all contractionary and that many U.S. banks are currently right around the 7% required capital. If these two points are true, then the Basel reform is a great new regulation. It will prevent banks from making reckless decisions causing them to fail, without raising interest rates too much. I think banks will be slightly more careful with their lending decisions, but interest rates will not be significantly affected. I also think that a more laissez faire approach has been tried in the past, with poor results when the economy begins to turn south. Even if the proposed regulation does stunt overall economic growth it will go a long way to prevent bubbles from happening.

    Sources:

    http://www.bloomberg.com/news/2010-09-13/the-meaning-of-basel-stiglitz-cohen-johnson-and-spillenkothen-speak-out.html

    http://global.factiva.com/aa/?ref=EC00000020100527e65t0000y&pp=1&fcpil=en&napc=S&sa_from=

  15. The intention of the Basel III accord is to sure up the shaky international banking industry. I believe the increased capital requirements might mitigate some potential risk (though I’m not sure a 7% requirement is enough), but it won’t fix the problem. I have two glaring concerns with the accord. First of all, in such a well oiled industry known for its adaptability to change, the banks will find a new way to skirt the rules with new innovative financial instruments (1). Not to mention they have 5 to 9 years to develop such instruments Secondly, the accord doesn’t clearly address the problem of valuing assets by risk. As Felix Salmon says in his blog, “…the whole Value-at-Risk structure gives banks every incentive to push risk into the tails” (2). Because the value of each asset can essentially be determined by each bank, they can tailor some assets to fall into the tails of their portfolio distribution. Once there they can be ignored as having low probability of failure. As an “after-the-fact” measure, this accord does a fair job at mitigating foreseeable risks, but doesn’t address any sort of unforeseeable risks.

    (1) http://moneywatch.bnet.com/economic-news/blog/maximum-utility/basel-iii/833/
    (2) http://blogs.reuters.com/felix-salmon/2010/09/15/the-biggest-weakness-of-basel-iii/

  16. Raising the amount of capital for reserves is a great way to decrease the risk of banks needing money for bailouts if another financial crisis hits us. Right now the amount that banks need to hold is very small which is why we’re in this situation. One article said that even though raising the required reserves would temporarily hurt the growth of our economy and raise borrowing costs, “it’s a small price that we have to pay” for a stable financial system. (2) China, however, already meets the Basel III requirements so they will be able to lend if they choose to. They have a lot of excess capital because they were uncertain as to how the rules would turn out. Also, since the rules are gradually going into effect over the next eight years, the growth of the economy wont be hurt as bad. Since the amount of required reserves is almost tripling, I don’t feel that it’s necessary to have an additional 2.5% buffer to protect against a financial downturn. I think that it should be up to the banks if they would like to hold excess reserves.

    1) http://www.nytimes.com/2010/09/08/business/global/08bis.html?_r=1&scp=4&sq=basel%20accord&st=cse
    2) http://www.nytimes.com/2010/09/13/business/global/13bank.html?scp=1&sq=basel%20accord&st=cse
    3) http://www.reuters.com/article/idUSTOE68D04420100914

  17. In the interest of discussing points that have not yet been touched upon, why should US regulators force these standards, made up by representatives from G-20 nations, on US banking entities? Will regulators/congress force these standards on US banks or banks that operate in the United States? Why are we worrying about capital requirements in the first place? Firms are perfectly capable of setting reserve levels at a percentage of capital that is both profitable for the firm and in line with investors’ risk preferences. Private enterprise, and I’m not just talking about the financial sector, has to understand that the government does not exist to fund their operations. It may sound crass and sophomoric to say that we shouldn’t have intervened as we did in 2008, but I am going to say it anyway.

    Financial markets are complex, and I have to think that people capable of creating such complex, opaque, and difficult to price instruments are just as capable of evaluating risk. So, they should be able to structure their balance sheets to reflect the risk tolerance of their investors. Yet, I think that institutions insured by the FDIC should be required to hold certain levels of capital or be barred from investing insured deposits in illiquid or difficult to price assets, for obvious reasons.

    At the end of the day, I don’t think that the Basel recommendations are going to really have a significant effect on the amount of lending by US firms in the near term.

    But, can we please just let insolvent and unsuccessful firms fail?

  18. The economy will not suffer today because of any capital requirements changes due to the timing of these changes, which won’t begin phasing in 5 years. I do think the economy will suffer both short and long run because of the shortcomings of the Basel Agreement. I think that the 7% requirement should be higher, even though the international average for reserves is 2%. The reason for this is I because of the risk-weighted system used by banks to value. As was stated in the Bloomberg article by Christine Harper, using this process uses a lot of mathematical formula and is generally very complicated, thus allowing it the process to be gamed. Compare that to the “high-bar” U.S. regulators are known for because they will use tangible assets instead of risk-weighted assets. It should be a priority to get the rest of the world on these standards in order to increase confidence in the bank not to game the risk weighted assets. But overall higher requirements is the right idea, I just think other changes need to be made as well and if the timeline were shifted up in order to get these changes made soon because they are needed.

  19. In general, the third Basel Accord is a set of well intentioned regulations, which if followed will improve the financial stability of the Basel committee. However it does lack some necessary provisions to provide supervision of banks reports of risk management and short term debt. While the risk-weighted value method has been retooled to give higher risk weights for securitizations and re-securitizations in the Basel III, it still relies on internal ratings that have been manipulated by financial institutions in the past to downgrade risk. To fight this abuse of the system, US is currently working to make the capital reserves requirement of 7% reflect the tangible equity of tangible assets (1). In addition, nothing has been done in the Basel III to curtail other misleading bank practices. For instance the act of window dressing allows bank to over-leverage themselves without investors or regulators knowledge. Recently, SEC voted to propose a measure to require banks to report their average debt on their statements to make the public more aware of the banks short term debt practices (2). Until regulatory measures like the ones proposed in the US become law throughout the Basel committee, the new reserve requirements may serve as an extra incentive for abuse in the system for the Basel III accord nations.

    (1) Paul Miller, http://www.bloomberg.com/news/2010-09-13/the-meaning-of-basel-stiglitz-cohen-johnson-and-spillenkothen-speak-out.html
    (2) http://online.wsj.com/article/SB10001424052748703904304575497661581547790.html

  20. Basel is trying to make lower risk of bank. But I think it is not a good idea. There is no reason to raise capital requirement up to 7%. Interest rate is low right now and people would borrow money from the bank. Bank can also make profit but capital requirement is too much so bank cannot invest to make profit. Basel should raise capital requirement before the mortgate back crush started. It will affect future time of US economy. At the present time, it looks like good idea to lowering risk but not fr the US Economy. It will be slow down the US economy China will make lower capital requirement to get opportunity of investment. China grow fast right now and this agreement will make china getting bigger.

  21. After reading the articles about the increased banking regulations, I have to wonder if these new laws will truly make an impact on the banking sector in the short run. Now the regulations are suppose to be met by 2019 which is a little more than 8 years away. To me eight years is a long time due to the fact that the future is uncertain. Our best and brightest have trouble predicting what will happen four months down the road; and the fact that these regulators are implementing laws for the future to help the present doesn’t seem right to me.

    Also, the criticism was that implementing these regulations sooner, instead of eighth years, would be a major shock to an unstable sector would make things worse doesn’t seem to fit. If, like the article said, most of the US is already meeting these regulations then how much of a shock would it truly be. Also how certain are the regulators that this would be a negative shock. Would having these laws in place now reduce the uncertainty we face today?

    I almost feel as if these regulations were made just to end the uncertainty of what would be done and to make it appear that we have fixed this crisis from repeating. As if it would be better to agree on this now so the public would have this certainty rather than taking more time to come up with a better option. What would happen if the banking sector was decided to be left alone and allowed to heal itself? Could it possibly “fix itself” in the same eight years that are trying to be regulated? I feel that the banking sector has to be either completely regulated or completely free market. Not this mix of both where certain parts are regulated and others parts aren’t; it makes things unbalanced.

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