The Gnomes of Basel

| Fri Jul. 16, 2010 12:24 AM EDT

And now for a post on the world's most boring topic: Basel III. This, you might recall, refers to the ongoing talks to update the Basel II Accord, which in turn was an update of the Basel I Accord — all three of which govern the amount and quality of capital that banks are required to hold. Roughly speaking, the more capital they're required to have, the lower their leverage and the higher their safety. To a considerable extent, this is the real ground zero for bank safety, not the financial reform bill that passed the Senate today.

So, how's it going? First some good news from Felix Salmon, who chatted with assistant treasury secretary Mike Barr today:

Barr said that the reforms passed today “were absolutely essential to the process,” and added something I didn’t know before — which is that they include Congressional authority for regulators to adopt all the Basel III standards. In other words, there’s no risk of Basel III getting caught up in Congressional opposition, as Basel II did. Once it’s agreed in Switzerland, US regulators are free to implement it immediately. “We got all the authority that we needed in this legislation that just passed,” Barr said. “The regulatory community will be ready to implement it in the US.”

That doesn't mean the regulatory community will implement it quickly, of course, but it's still good news. Now here's some bad news: the rules are almost certain to be watered down thanks to all the usual tribal squabbling. The Wall Street Journal reports:

The French are demanding changes that would allow their three largest banks — Societe Generale SA, Credit Agricole SA and BNP Paribas SA —  to continue owning insurance subsidiaries without facing steep penalties. The Germans and French want banks' minority investments in other institutions to count toward capital standards. The Japanese have raised concerns about no longer counting deferred tax assets as capital. U.S. officials want banks, such as Bank of America Corp. and J.P. Morgan Chase & Co., to continue to be allowed to count mortgage-securitization rights as capital.

On the testy issue of the leverage ratio — limiting how much banks can borrow — negotiators from several countries are looking for wiggle room. Germany, for instance, is worried about the impact on Deutsche Bank AG. They want regulators to be given discretion over how rigidly to enforce the new ratio, rather than having binding global rules. Other officials counter that that would undermine the intent of the rule. In a temporary fix, officials have said they would begin with an "observation period" for the leverage ratio, and there is now a major disagreement over what to do after that.

You may also recall that I posted a couple of days ago about the dangers of a run on the shadow banking system, something that was one of the major causes of the 2008 panic. Bank runs are pretty much a thing of the past in commercial banking because they're funded by retail deposits, and since these deposits are insured by the FDIC it means that retail customers like you and me aren't likely to panic and pull all our money out during a financial crisis. It's a different story for shadow banks, which typically rely heavily on short-term wholesale funding and therefore run the risk of their funders suddenly pulling out their money at the same time if they fear a bank is about to go under.

What to do about this? Answer: require banks to rely more on stable, long-term funding. This is called the "net stable funding ratio," and the banks are fighting it:

Some analysts say that the requirement alone could cost banks trillions of dollars in new funds, and officials could postpone or shelve the idea, people familiar with the matter said....Those studies in general show that the version of the rules outlined in December could require banks world-wide to raise nearly $1 trillion in new capital, according to people briefed on the process. That's considerably less than the multi-trillion-dollar estimates published by some industry groups.

One big concern is whether forcing banks to hold more capital and otherwise be more risk-averse will hurt lending, and thus strangle global economic growth, a theme that banks have been sounding loudly.

Italics mine. As Felix says in a different post, it would be nice to know just who's saying this. Like him, I imagine these are mostly banking industry lobbyists whose statements should be very seriously discounted:

The standard WSJ “people familiar with the matter” formulation simply isn't good enough here, especially when it's used ambiguously: are the “people familiar with the matter” saying just that the liquidity requirements could be shelved, or are they also the source for the multi-trillion-dollar scare estimates?....Banks seeking to influence the outcome are naturally going to try to set the tone of the debate by talking strategically to members of the press. Anybody reporting this story should assume that they're being used, somehow. And be very careful in what they say and how they say it.

Anyway, that's the latest. The news overall, I'd say is middling. There's a tremendous amount of lobbying going on, and the eventual rules will almost certainly be weaker than they should be. However, negotiations do seem to be proceeding fairly quickly (the Basel II process took five years) and there does seem to be a decent consensus about tightening up the rules on how to account for various kinds of capital. The net stable funding rule, if it survives in credible form, will also be welcome. Stay tuned.

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