The new agreement on global banking regulation known as Basel III has generated a spirited debate in the banking community and the financial press. Advocates of the new rules, which require banks to hold higher levels of core capital and liquid assets, suggest that the global banking community has finally found a reasonable standard that ensures bank stability without undue infringement upon profitability.
Opponents suggest either that the new rules are woefully inadequate to prevent another financial crisis, or that they are strenuous enough to cut off the banking sector at its knees.
To understand how we arrived at this point in the evolution of global banking regulation, we must look beyond these strident debates and first understand the political processes that drive the creation of international regulatory standards. I call these processes the “quiet politics of Basel.”
We do not normally think of financial regulators as political agents, but regulatory agencies are in fact subject to political constraints and bureaucratic incentives, even if these influences are not immediately visible. Scholars trained in economics are familiar with the concept of a “principal-agent relationship,” in which the principal delegates responsibility over a task to an agent. In the case of financial regulation, legislatures or other government actors delegate regulatory authority to an agency or agencies, which then have considerable discretion to set the rules for the financial industry.
Regulators, wary of intervention by politicians, generally engage in a balancing act as they tighten regulations after bouts of instability and then relax those regulations over time as the banking industry presses for greater flexibility. Severe instability, such as the episode we just experienced during the so-called Great Recession, often sends regulators to the international bargaining table to seek an agreement with their foreign counterparts.
To see the quiet politics of Basel in action from the perspective of the U.S., consider the events that led to the creation of the first Basel Accord in the late 1980s. Beginning early in the decade, U.S. commercial banks showed troubling signs of weakness as the debt crisis in Latin America revealed their precariously small capital cushions.
The collapse of Continental Illinois in 1984, then the largest bank failure in U.S. history, was only one of 80 bank failures that year. A whopping 468 banks collapsed between 1985 and 1987, more than in the prior 30 years combined. Bank regulators responded relatively quickly to the growing crisis.
The three key agencies − the Federal Reserve, the Office of the Comptroller of the Currency (OCC) and the Federal Deposit Insurance Corporation (FDIC) − each announced a set of capital adequacy guidelines in 1981, and Congress legislated a substantial overhaul of bank supervision in 1983. In the wake of the Continental Illinois failure, Congress summoned the head of the OCC to a hearing to explain to the public why his agency presided over such a fiasco. Not surprisingly, the OCC and the other agencies subsequently tightened capital requirements again in an attempt to stem the tide of bank failures and prevent any further public humiliation.
As an additional strategic complication, regulators had to weigh the benefits of tighter capital requirements against the costs to bank profitability and competitiveness, and these costs were increasing dramatically as banks in other countries − especially Japan − began to encroach upon the market share of U.S. banks.
By 1987, Japan had nine of the ten largest banks, based on assets, in the world, up from just two banks five years earlier. More important, the U.S. was home to a growing number of branches of Japanese banks, and the assets of these branches more than quadrupled between 1981 and 1988. With capital requirements becoming more and more stringent for U.S. banks, foreign banks such as Sumitomo and Fuji had a distinct competitive advantage. Japan’s Ministry of Finance provided an implicit guarantee of support for the banks that it supervised, thereby enabling them to maintain relatively thin capital bases.
As pressure from Congress increased throughout the 1980s and confidence in the U.S. banking system faltered, the competitive threat from Japanese banks prompted U.S. regulators to engage in international regulatory cooperation. In essence, regulators shifted to the international bargaining table to address their domestic failings.
The strategy was straightforward: push for a global capital-adequacy standard that addressed the shortcomings of the existing regulatory structure for U.S. banks, and thereby stem the rising tide of bank failures while mitigating the international competitive implications of more stringent regulations. This strategy, with the assistance of British regulators, ultimately hastened the creation of the Basel Accord in 1988.2 The Accord established a standardized risk-weighting system for bank assets and mandated a minimum 8 percent capital ratio.
The politics of the second Basel agreement were even quieter than for the first agreement. In short, the 1990s and early 2000s were a remarkably stable period for banks, and the competitive threat from Japan largely receded as that country entered a prolonged recession. Banks argued that a revised capital accord should reflect modern risk management techniques, including complex statistical assessments of risk, and regulators agreed. With elected leaders as tacit supporters, the Basel II agreement relaxed the rigid rules of its predecessor by allowing banks to calculate market risk based on in-house formulas.
How did we arrive at Basel III? One might imagine that the worst financial crisis since the Great Depression would generate extraordinary political pressure on regulators, but this was not the case. On the contrary, at the height of the crisis, bank regulators appeared to be reacting to an exogenous act of nature − like a hurricane − rather than cleaning up a mess that they might have inadvertently caused.
The Great Recession was in fact more than a garden-variety banking crisis, as it involved financial firms of all stripes (commercial and investment banks, insurance firms, etc.) and triggered high unemployment, falling home prices and sluggish growth.
In contrast to the Congressional finger-pointing of the 1980s, elected leaders have been less eager to place blame on bank regulators and more likely to engage in debates over fiscal and monetary policy. The Dodd-Frank Act − the main piece of legislation to emerge from Congress in the wake of the crisis − allows regulators substantial discretion in filling in the holes in its over 1,000 pages of rules. To date, regulators have created only 155 out of the 398 rules required by the legislation, but members of Congress seem unconcerned about their slow progress.3
Basel III reflects this political reality. Unlike Basel I, the new agreement does not constitute a wholesale revision of bank capital standards. Indeed, the agreement retains many of the key features of Basel II, including in-house risk assessments and reliance on rating agencies, which critics suggest might have contributed to the crisis just a few years ago. However, unlike Basel II, the new agreement cannot be characterized as a retreat from regulatory stringency. New rules such as a liquidity coverage ratio − which ensures that banks have sufficient high-quality liquid assets to withstand a sustained bout of market turbulence − and a minimum leverage ratio reflect regulators’ increased concerns about the quality of banks assets and the possibility that in-house financial models could go awry.
Full implementation of Basel III is not expected until 2019. Many developments could occur before then, possibly leading to a modification of the rules. A new high-profile bank failure, for example, could lead to new pressures for higher capital levels or a re-evaluation of the definition of high-quality liquid assets, whereas a period of stable growth could give regulators an excuse to add further delays to implementation. The debates in the financial community will continue, and the politics will always be humming behind the scenes.
- This is obviously a condensed narrative of the genesis of the Basel Accord. For more details, see Singer, David A. Regulating Capital: Setting Standards for the International Financial System. Ithaca, NY: Cornell University Press, 2007.
- See Ted Kaufman, “Set Up to Fail,” Forbes, July 19, 2013. http://www.forbes.com/sites/tedkaufman/2013/07/19/set-up-to-fail-dodd-frank-leaves-bank-regulators-overwhelmed-underfunded/