The Basel Committee on Banking Supervision is a joint project of the G-20 central banks. It produces recommendations and best practice guidance that national central banks are expected to incorporate into their domestic banking regulations.
The most important of the Basel Committee's functions is producing the Basel Accords, which provide guidance as to minimum capital requirements that national regulators should demand of their banks.
Basel II was the accord in place during the financial crisis of 2007-2008 and took a lot of heat for failing to prevent the credit crunch.
A new round of negotiations is currently underway to produce a revised accord known as Basel III.
The new accord would make many changes in bank regulation. Here are the main points:
Basel III: Banks will have to increase their core tier-one capital ratio to 4.5% by 2015. In addition, they will have to carry a further "counter-cyclical" capital conservation buffer of 2.5% by 2019. Any bank that fails to meet the new requirements is expected to be banned from paying dividends to shareholders until it has improved its balance sheet.
Financial supervision: The G20 wants closer supervision of systemic risk at local and international levels.
Derivatives: The G20 has called for greater standardisation and central clearing of privately arranged, over-the-counter contracts by the end of 2012.
Hedge funds: US reforms are in line with the G20 pledge that funds above a certain size should be authorised and obliged to report data to supervisors. A draft EU law includes private equity groups and restrictions on non-EU fund managers seeking European investors.
Accounting: The G20 wants common global accounting rules by mid-2011.
Credit rating agencies: The G20 wants them registered and supervised by the end of 2009. The EU has adopted a law mandating registration and direct supervision that takes effect this year. US legislation passed this year includes similar provisions.
Pay: The G20 has endorsed principles designed to stop bonus schemes in banks from encouraging too much short-term risk-taking.
The bottom line is that it will require banks to raise hundreds of billions of dollars in new capital. With what effect on the credit markets? Well, that's where things get interesting:
Jaap Barneveld writes that:
Simon Johnson, editor of a highly recommendable weblog (www.thebaselinescenario.com), drew my attention to an interesting letter published in the Financial Times concerning the reform of the capital requirements for banks (Basel III). The letter has been written by a significant amount of academic experts that argue that the proposed regulation fails to eliminate the key structural flaws in the current system. The banking lobby argues that by requiring banks to hold more capital, the economy will be hurt and growth will be undermined. The academic experts beg to differ, based on surprisingly basic and fundamental concepts, that everyone who ever took a foundation course in corporate finance ought to know:
“Some claim that requiring more equity lowers the banks’ return on equity and increases their overall funding costs. This claim reflects a basic fallacy. Using more equity changes how risk and reward are divided between equity holders and debt holders, but does not by itself affect funding costs.”
Remember Modigliani & Miller? The capital structure of a firm is irrelevant to its value. However, because interest is tax-deductible, leveraging can create value. The experts:
“Tax codes that provide advantages to debt financing over equity encourage banks to borrow too much. It is paradoxical to subsidize debt that generates systemic risk and then regulate to try to limit debt. Debt and equity should at least compete on even terms.”
The experts point to the (also very basic) moral hazard problem inherent to the use of too much leverage:
“High leverage encourages excessive risk taking and any guarantees exacerbate this problem. If banks use significantly more equity funding, there will be less risk taking at the expense of creditors or governments.”
...
As Simon Johnson notes, the fact that so many important scholars are weighing in on the debate and basically are telling the bank officials that their analysis is just wrong, is pretty huge. The experts’ main point, that “ensuring that banks are funded with significantly more equity should be a key element of effective bank regulatory reform”, is supported by a recent paper that is prepared to be published in the Journal of Economic Perspectives.
Technically, the Basel Accords aren't legally binding on member states. They are hugely influential, however. As a result, we need to consider the impact compliance with Basel III would have both on internal US credit markets and the competitiveness of US banks globally. If the critics are right, we could see a dramatic tightening of credit--especially trade credit--and a resulting decline in trade and GDP.
At thew G-20 meeting, the second round of quantitative easing (QE2) has taken prominence. But keep your eye on what happens to Basel III. In the long run, it will matter more.
