The idea behind the new rules drawn up by central bankers to make banks sounder is straightforward enough: make banks hold a fatter cushion of capital to use if more loans than expected turn bad. It is in turning that simple principle into effective regulatory practice that is difficult.
The Basel Committee on Banking Supervision has announced a set of rules strengthening capital requirements for the banking system that will be presented to G20 leaders at their Seoul summit in November. These, in short, raise the banks’ required capital ratios from 2% to 7% though there is a lot of devilish detail in that, particularly around the new 2.5% capital buffer that is being created and how to risk-weight a banks’ assets. That detail is not trivial (defining capital quality has been an Achilles’ heel of the existing Basel accords), and has been the subject of a lot of national horse trading, particularly across the Atlantic, as has the implementation timetable. The rules will be phased in between 2013 and 2019, national regulators will retain a lot of flexibility in how they implement them and there is no agreement yet on what to do about what are called “systemically important banks” beyond a general sense they they should face stricter requirements than other banks.
Many big banks already meet the new rules, so their impact will be modest. Had they already been in place before the recent financial crisis it is by no means certain they would have forestalled it; nor are they likely to prevent the next one. They are a proper statement of intent by governments that banks should have sufficient capital to cover their exposure to risk, and, along with new rules on liquidity are the core of any financial regulation reform.
However, they only go so far in addressing the primary regulatory failure of the last crisis, the inability of regulators to identify building systemic risk. Last time round their risk models could not measure counterparty risk and thus the potential of contagion. The banks’ use of off balance sheet vehicles and complex derivatives products attracted lower risk weightings and so encouraged leverage; the new rules will discourage that and scratch deeper at risk weighting assets, but only up to a point and at a leisurely pace, giving banks plenty of time to work out how to get round them and animal spirits to regain their appetite to do so.