ECB President Jean-Claude Trichet was in ebullient mood. The new, recently agreed upon rules for banks were a “landmark achievement”, Trichet boasted. They “will enhance banks’ safety and soundness, thereby strengthening the stability of the financial system as a whole”, Europe’s most important central banker said. “That, in turn, will improve the ability of the financial sector to serve as a source of sustainable growth for the broader economy.”
Trichet said this in June 2004, and he was talking about the “Basel II” regime.
Today, seven years later, a lot of academics are convinced that this regulatory framework has precipitated the worst financial crisis since the Great Depression. Under Basel II banks had been able to engage in reckless business. They became highly leveraged and accumulated enormous risks. Several financial institutions that looked healthy by Basel II standards looked into the abyss in 2007 and 2008. Prior to the crisis, financial institutions had been horrendously undercapitalised.
Basel III is supposed to fix this awkward situation.
In September 2010, the world agreed upon a new, more stringent regulatory regime. In 2019, for each 100 pounds of lending, banks have to have equity capital of 7 Pounds on their books. At the moment, they only need to have a capital cushion of 2 Pounds. On top of that, the definition of core capital will be much stricter under Basel III. Banks will not only have to have more equity, they are also forced to have better equity.
Guess how Jean-Claude Trichet sees Basel III? Well, exactly. „It’s a major, major achievement”, he said in September 2010 according to Bloomberg.
However, Adair Turner, chairman of the Financial Services Authority, the UK’s financial watchdog recently expressed significant doubts:
“The world’s regulatory authorities […] thought that they had it right when they agreed Basel II, and that was clearly wrong. So have we now got it right?”
Probably not. There is mounting evidence that Trichet’s judgement will be proven wrong again. Several academic papers come to the conclusion that Basel III is way too soft and not sufficient for guaranteeing financial stability in the long run. Banking crises are almost as likely as they used to be. Additionally, these papers reveal that the arguments the financial industry and its lobbyists are using to thwart tighter regulation are deeply flawed and should not be taken seriously.
Hence Adair Turner has recently stressed in a speech (“Leverage, Maturity Transformation and Financial Stability: Challenges Beyond Basel III”) at Cass Business School in London:
“It is important to recognise that ideal equity ratios would be higher than Basel III, and that the system will therefore remain more vulnerable to instability than is ideal. […] In an ideal world we would impose higher equity requirements than Basel III. In the absence of that ideal, we need to reduce the probability and impact of [Systemically Important Financial Institution] failures. The best way to do that is with equity surcharges. […]And some countries may choose to progress to higher capital standards than Basel III for all of their banks.”
In papers economists affiliated with the Bank of England (“Optimal Bank Capital”) and the National Institute of Economic and Social Research (“Is There a Link From Bank Size to Risk Taking?”) make similar points. “A capital ratio which is at least twice as large as that agreed upon in Basel would take the banking sector much closer to an optimal position”, David Miles, Jing Yang and Gilberto Marcheggiano (all affiliated with the BoE) have recently concluded in a paper entitled “Optimal bank capital”. Macroeconomic simulations show that equity ratios between 16 and 20 percent are necessary for significantly reducing the risk of further financial crises.
Economists also take issue with a number of other parts of Basel III. Academics affiliated with the National Institute of Economic and Social Research additionally recommend an even more stringent definitions of equity. Softer kinds of capital of inferior quality (“Tier 2″) – for instance subordinated debt – should not be considered as equity at all. (“Tier 2 Capital and Bank Behaviour”)
Martin Hellwig (Max Planck Institute, Bonn) severely criticises how the credit risks are calculated (“Capital Regulation after the Crisis: Business as Usual?”) Rafael Repullo and Jesús Saurina take issue with the countercyclical capital buffers (“The Countercyclical Capital Buffer of Basel III: A Critical Assessment” ) .
Banks bent over backwards to fight tighter regulation. Their most important argument against higher safety cushions is this: If financial institutions are forced to put more equity aside, they can lend less money and have to charge higher interest rates. These tighter credit conditions would significantly slow down economic growth and prosperity.
However, this point of view does not hold the water, as theoretical and empirical papers show. The BoE economists, for example, went to their archives and found that between 1880 and 1960 the leverage of the banks in the UK and the US was only half as high as it is today. Accordingly, the equity cushion of the banks was much higher. However, this neither slowed down lending nor economic growth. David Miles and his co-authors assert:
“In the UK and in the USA economic performance was not obviously far worse, and spreads between reference rates of interest and the rates charged on bank loans were not obviously higher, when banks made very much greater use of equity funding. This is prima facie evidence that much higher levels of bank capital do not cripple development, or seriously hinder the financing of investment. Conversely, there is little evidence that investment or the average (or potential) growth rate of the economy picked up as leverage moved sharply higher in recent decades.”
This empirical analysis supports the conclusion of a joint paper by four economists affiliated with Stanford University and the Bonn Max Planck Institute. Anat Admati, PeterDeMarzo, Martin Hellwig and Paul Pfleiderer meticulously analysed the arguments against tighter capital standards. (“Fallacies, Irrelevant Facts, and Myths in the Discussion of Capital Regulation: Why Bank Equity is Not Expensive”)
Their results are straightforward:
“[T]here are no significant social costs of increasing equity requirements for banks, politicians and regulators should not be overly concerned with threats that credit markets will be adversely affected by increasing equity requirements. High equity requirements need not interfere with any of the valuable intermediation activities undertaken by banks.”
One of the most important fallacies in the debate about more stringent capital ratios is that most people mix up the private and the social costs. From the point of view of individual bank, equity indeed is more expensive than leverage – first and foremost thanks to the tax system. Interest paid on debt resembles costs. Hence, the banks have to pay fewer taxes if the finance their business with debt rather than equity. The tax benefits of debt resemble a significant public subsidy, as Admati et al. point out:
“In fact, it is quite paradoxical that the government subsidizes the leverage of the banks at the same time that it recognizes that this leverage is socially very costly and considers imposing stricter capital requirements to prevent the banks from taking advantage of this subsidy.”
This is good for shareholders but detrimental from a macroeconomic perspective. Higher leverage in the banking sector means higher risks and more financial instability. Additionally, the taxes that banks with bigger equity cushions have to pay are not lost but can be invested in the economy by the government. David Miles and his co-authors assert:
“Indeed the extra tax receipts could, in principle, be used to neutralise the impact on the wider economy of any increase in banks’ funding costs.”
Higher equity cushions also mean that, mathematically, the return on equity (ROE) declines. However, the RoE is not a meaningful indicator for judging the performance of banks. The main flaw is that ROE does not take into account which kind of risks the bank faces earning its returns. As Admati and his co-authors point out:
“Using ROE to assess performance is especially problematic when comparisons are made across different capital structures. The focus on ROE has therefore led to much confusion about the effects of capital requirements on shareholder value.”
Additinally, since higher equity cushions would mean that banking would become more stable and less crisis-prone, investors would become less demanding, as Admati et al. rightly point out:
“Because the increase in capital provides downside protection that reduces shareholders’ risk, shareholders will require a lower expected return to be willing to invest in a better capitalised bank.”
The macro economic damage of tighter equity rules would be very small and negligible. Each percentage point of higher equity rations cost 0.09 percentage points of growth, economists have recently estimated in a working paper published by the Bank for International Settlement (BIS) (“BASEL III: Long-term impact on economic performance and fluctuations”).
If the Basel III quota were raised by 8 percentage points to 15%, this would slow down economic growth by 0,7 percentage points. If one takes into account that banking becomes less risky with raising equity ratios and banks will pay higher taxes, the net losses are significantly lower, the paper by David Miles at al. shows. Given the horrendous economic havoc of banking crisis, this would mean the tighter rules would pay for themselves even if they only thwart one single financial meltdown.