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[Music]
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We're meeting today with Wharton Finance
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Professor Richard Harring to discuss the
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recently approved Basel 3 Accords and
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how they will affect international bank
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capital requirements. Thanks for joining
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us today. My pleasure. I guess we should
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start by saying that the Bosel Committee
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does not refer to it as Basel 3. They
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have studiously avoided the term. uh
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they'd rather think of it as just sort
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of a addition to Basel 2, kind of like a
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Windows program that is issued as 2.4 or
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something. Um but it is uh in many ways
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a marked change. Um it's tidying up some
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mistakes that they made in Basel 2,
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which isn't to say that they've actually
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corrected them. Um but it also is
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reflective of a new world governance
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system for uh the international
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financial system. Um before last year
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really uh the top level governing body
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was the group of 10 leading countries
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and those included only one Asian
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country Japan and they were all wealthy
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countries. Um, it was actually 11
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because they put Switzerland in because
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it's it's a financial center, but apart
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from that, it was really a G10 creature
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and it was a G10 central banks and the
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Basel committee reported the G10 and um
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that made sense when it was formed in
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1974 because those countries did control
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about 80% of uh world financial
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activity. But the whole balance of
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economic power and wealth has shifted to
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Asia in a dramatic way over the last few
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years. So that it no longer really made
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sense to make rules for the world
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financial system with a group that was
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that
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unrepresentative. Um so we now have the
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group of 20 that includes um all of the
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brick countries Brazil, Russia um uh
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India and China as well as Indonesia and
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other leading uh developing countries.
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So we have about the same proportion of
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world financial activity covered
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actually a whole lot more of the world's
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population and um a whole lot more of
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the world's economic output. Um but it
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does make for a much more heterogeneous
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group.
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It was surprising in a way that they
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were able to agree on what they wanted
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to do with the financial system because
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it's usually much more difficult to to
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reach consensus in a heterogeneous group
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than a small one that's homogeneous. But
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last year um they met in Pittsburgh. Um
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it was uh it's hard for them to meet
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because they're a target for everybody.
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And so Pittsburgh is kind of a nicely
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protected place because you can sort of
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close down the bridges and and uh have
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it uh uh safe. And I think Obama wanted
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to show off a US city that had kind of
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regenerated itself. But they actually
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came out with a very clear set of things
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they wanted to improve with the world
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financial system and they created a
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body. They transformed the financial
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services forum into the financial
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services board that was charged with
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really carrying out those things and
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dividing it among the existing
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structures we have. Well, the Basel
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committee which used to be basically the
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G10 plus Luxembourg in Switzerland has
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now has 27 members and so the uh
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decision process is in some ways much
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more reflective of a a broader range of
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interests. Well, the problem that they
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set out to fix, uh, one of the most
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obvious problems, and there were
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numerous ones, is that, um, they had
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made a really serious mistake in Basel 2
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in ignoring the numerator in the minimum
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capital standard, the numerator and the
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middle and the the riskadjusted capital
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standard was supposed to um compare
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capital as the numerator to risk
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weighted assets.
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And the risk weights were supposed to
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indicate how risky the asset was. Well,
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there were huge problems in the risk
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weights. Uh we can get to that later.
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But the real problem with the capital
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definition is that they didn't even
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reconsider it. And the reason they
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didn't reconsider it is that when they
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originally negotiated Basel 1, about 85%
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of the time was taken up trying to agree
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on a definition of regulatory capital.
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Capital is one of those words that can
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have at least 10 or 12 different
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definitions. They started with capital
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to regulate banks because every single
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country had a capital ratio. But when
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you started looking at them in detail,
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they were all very different. In the
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United States, we had a huge proportion
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of loan loss reserves. Uh the Japanese
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counted unrealized gains on uh real
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estate and stock. Um the French that had
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just nationalized their whole banking
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system counted lots of preferred shares.
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And so that's why it took so long for
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them to come up with a right because and
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agreed. They were smart enough to know
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that if um you agree on a definition of
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capital that doesn't look like the
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capital we have, you're going to make it
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hard on our banks. Well, the Germans
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were sort of one end of the spectrum at
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that time, although they've now
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switched. And they thought that they we
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would ruin the rigor of the German
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regulation, in fact, banking regulation
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in general, if we went much beyond
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equity. and everybody else wanted
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something in addition to that. So they
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resolved it by having two kinds of
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regulatory capital. They ended up
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eventually with three kinds, but the
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third kind was never really used. Um but
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the first kind reflected the German view
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and it was
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originally shareholders equity um
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retained earnings and a very restricted
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kind of hybrid capital. It was a
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non-cumulative perpetual preferred
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security, which meant that if you missed
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a dividend, you didn't have to make it
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up. And perpetual meant that you never
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had to repay the principal. So like
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equity, it was with you to absorb loss
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without driving you out of business. The
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problem with debt contracts is that they
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can absorb loss, but only if you fail.
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And so all of this other stuff was
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really not very useful. Well, over time,
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banks, and this is a concern with the
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the uh very long leadin period to uh
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Basel 3, banks sort of whittleled away
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at that tier one definition because it
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was it was they considered the most
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burdensome kind of capital to have
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because issuing equity is is expensive.
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Um, and so what was originally a 4%
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requirement became generally sort of a
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2% requirement with a lot of other stuff
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that was nothing like equity. Probably
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the most egregious example of that was
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that banks were able to count as cap as
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tier one capital deferred tax assets.
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Now, deferred tax assets are what you
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get when you make losses that you can't
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deduct because you don't have any
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income. Well, it's a kind of crazy thing
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to count as capital to protect you
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against going out of business because
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that's the time you're least likely to
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have the expectation of making income.
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So, that made no sense at all. The
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others were driven by trying to take
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advantage of tax laws because a lot of
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this is caused by um the asymmetry in
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the tax treatment of dividends and
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interest. Um, in general, governments
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will permit interest payments to be
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deducted for tax purposes, but dividends
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can't be. Uh, so there is an obvious
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incentive for people to try to finance
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themselves with debt instruments. and
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investment bankers spent a whole decade
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trying to invent instruments that were
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enough like equity that the regulators
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would accept them but enough uh like
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debt that the um tax authorities would
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permit them to be deducted. So you ended
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up with this very debased system. So
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they they whittleled that down to 2% and
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now uh bezel 3 is bringing it back up to
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4%. Yeah, because one of the most
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embarrassing things that happened um
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during this crisis from a regulator's
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point of view is that in every case
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where a bank went under had to get a
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huge intervention. The regulators said
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well in the last reporting period they
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actually had way above the minimum
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required capital which simply means that
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our capital requirements were were kind
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of
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uh trivial and unimportant. Whittleled
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away too much. Yeah. Well, they were
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they were simply uh not uh sufficient.
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Uh and they were not what they were
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intended to be. Um as a result, the
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market paid no attention at all to
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regulatory capital. And that I guess is
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in the end the the thing that was uh
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most demeaning to the regulators because
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they could say all they wanted about
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regulatory capital and it made no
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difference in the market expectation.
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They were looking at tangible equity. Um
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so one of the first things to fix was
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the numerator and that meant more higher
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quality capital and in the eyes of
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regulators higher quality capital is
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equity because that's with you to absorb
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losses and let you continue doing
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businesses. And so they um not only uh
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have required more equity capital but
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they've tried to require three kinds of
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equity capital actually four. Um, the
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first one is pretty much like tier 1 was
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supposed to be, but rather than being
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4%, it's now 4 1.5%. Um, there's kind of
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exaggerating by saying there's this huge
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increase in capital requirements from 2
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to 4 and a half. Well, if you look at
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the original Basel agreement, they're
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really only going up half a percent for
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the minimum, which isn't very
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impressive. Um, then they're adding
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another
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2.5% for what they call a buffer zone.
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And this is an attempt to um have the
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market accept the fact that capital can
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decline without making the bank more
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unsafe. Um what they may have done
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inadvertently however is create uh yet
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another problem because in principle
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when a bank starts eating into that
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buffer they're going to stop it from
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paying dividends and there may be
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sanctions on salaries and that sort of
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thing. Um and that could cause the
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market to lose a lot of confidence. I
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there should be some sanction, but
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ideally you'd like it to be graduated
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from something trivial to something more
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serious. Um, and it's not at all clear
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that that's the best way to handle the
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buffer. it may be a lot better to use
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something that is colloially called a
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Koka or a con mandatory convertible uh
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debt um which is a more complicated
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thing but it would allow tanks to get
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the tax benefit of having uh an interest
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thing but give you equity when you
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needed it. So, our banks, do you think
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going to voluntarily add yet another
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buffer on top of the buffer so that they
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don't Well, yeah, because um you know,
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living in the uncertain world, we do um
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nobody can be certain what you're going
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to earn in a year and you don't want to
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be in the position of having to not pay
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dividends. So, uh even as we saw with
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current capital requirements, banks
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voluntarily maintain a buffer above the
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minimum and so they'll probably maintain
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a buffer above that. But the third piece
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of it which is innovative and if it had
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been done well would have um been a real
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improvement is to deal with the fact
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that having risk adjusted capital
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requirements makes them much more
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proyclical than they otherwise would
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have been because it means that as the
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economy
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improves risk goes down. So the
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denominator goes down assuming you have
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the same capital. In fact, you'll be
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increasing it because retained earnings
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will increase. You have bigger lending
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capacity to sort of blow up the boom
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even larger. But on the way down, as
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risk increases, the denominator
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increases and as you get losses, capital
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declines. And so, you're going to
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contract lending even more. So, this is
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a you see this as a flaw in how they've
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designed this at this point? Yes, it's
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one of the the huge costs of having um
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riskadjusted capital requirements. Um,
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and they've tried to correct this in a
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very timid way. Um, and what they have
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done is to put it under pillar two,
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which means that nobody's going to know
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what they do because that's a secret
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agreement between the bank and and their
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supervisor, but they're going to add on
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a um an amount up to 2%. Could be
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anything from 0 to 2%. We won't know.
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when they think that demand is getting
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out of hand or the supply of credit is
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getting out of hand. So that will not be
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transparent. That will not be
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transparent. Um but it's intended to
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slow down the expansion so you won't
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have a pick a crash. The problem is that
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um inherently it's just very very
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difficult for a bank examiner making say
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75 or $80,000 to go into a $10 million a
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year banker and say uh I know you're
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very profitable but I think that you're
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sitting on a lot of risk. Now, it's true
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they are because it's a standard saying
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that the worst loans are put on in the
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best of times. And we know that's true.
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But it's not very credible when uh the
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bank is in such good shape. Regulators
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have a lot more uh leverage when things
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get bad because they have uh some
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benefits to give out. So, um I think
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it's very unlikely that this is ever
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going to be imposed because it's always
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ambiguous about whether we are in a
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bubble or whether we're we have
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improving fundamentals because usually
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there's a little bit of each underneath.
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So, you've me you've mentioned a couple
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weaknesses here. Could you just kind of
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Well, then there's a fourth kind of
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capital before we get to the the rest of
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the weaknesses. Um and that is a
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leverage ratio. Um, and that's the one
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reason that that our banking system is
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actually in less trouble than Europe's
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because uh almost single-handedly Sheila
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Bear, the chairman of the FDIC, held on
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to the leverage ratio in the United
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States, which is um a a ratio of tier
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one capital to unweighted assets, but
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taking off balance sheet commitments on
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in their loan equivalent form. uh and so
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that put a limit on how much leverage
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you could have. Well, it turned out
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certain of the European banks, some
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leading banks like UBS and Deutsche Bank
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had leverage ratios as high as
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50%. So assets to to tangible equity
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were so large that you had to be
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virtually perfect in risk management to
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be able to survive. Um it Switzerland
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became terrified when they figured it
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out and so they too have put in a
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leverage ratio because their banks are
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literally too big to save. They're both
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so large outside Switzerland that that
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it's large relative to their
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GDP. Um but the other European banks are
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not so sure they want to do it. So the
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compromise that was made is that they're
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going to aim for maybe a 3% leverage
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ratio, but it will be under tier 2. So,
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we're not going to really know. And they
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aim ultimately to make it tier one and
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an explicit requirement, but that may or
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may not happen because the Europeans are
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clearly dragging their feet. The Germans
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in particular, which is ironic given
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their earlier position, but they have a
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very weak stateowned sector and it's
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very hard for them to um raise equity.
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Uh
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moreover, the rule uh was made that you
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can't count loans from government as
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tier one and uh that that was a blow to
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Germany. And so I think the compromise
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was they got a pillar two leverage
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ratio. One of the other things about
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this that's uh striking is how long a
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delay there is before it's actually
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implemented. And of course the banks
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were afraid that this would um adversely
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affect them economically and so they
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they won at that buffer time. Um but um
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well they actually wanted lower
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standards. Uh but uh the compromise
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ended up being buffer time because uh
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most of the banking um so in fact you
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can read them on the BIS website in
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comments but uh all the the major bank
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lobbying groups and many of the major
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banks sent in arguments that look if you
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do this you're going to send the world
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economy into spiraling recession or
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depression because um if you raise
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required capital we're going to have to
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raise spreads on loans and um we're
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going to lend even less than we are now.
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And when you break down the argument
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into pieces, there's an element of truth
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to what banks are saying in the sense
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that
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um from the standard finance point of
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view, if they raise equity, they should
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be compensated in a lower cost of debt.
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But that's not going to happen for banks
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in general because we have guaranteed
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all of their debt. The one thing we did
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not do in the United States in any bank
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failure was let anybody who had a debt
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claim on a bank suffer except for layman
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brothers. And so they're not going to
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get the relief in a lower cost of debt
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that they could expect in a free
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capitalist system. So uh you know you
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can understand why they view that as a
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pure cost. But the reason that this long
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phase in period is thought to be helpful
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is that it's rather expensive to um do
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an IPO to raise debt. Um the big
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transactions costs and given the fact
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that banks are kind of in the doldrums
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at this point. Uh their PE ratios are
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not very attractive. So they'll have to
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pay a lot. Um so what they computed was
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how long it would take a bank to retain
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earnings to get to these ratios and you
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know you can make various assumptions
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about how that will happen but uh it it
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ends up to be something like 2018 or
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2020. Um,
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and one of the subsidies we do not
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count, but we should in uh figuring out
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how much we're subsidizing the banking
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system is that we're really subsidizing
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those retained earnings by keeping
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interest rates so low that they have a
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natural build in spread that's just
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huge. And uh so there is some reason to
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believe they actually will retain the
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earnings to get there and you know once
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they're there I think most of the costs
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were really transitional costs. Um but
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there's a risk in that sort of policy.
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If we were to have a double dip
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recession,
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uh which I think is not impossible,
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uh we would be in even worse shape than
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uh we were before because uh banks would
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be
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um still unprepared to to deal with it.
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Um and uh the other problem is a
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political one. The longer you wait to
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phase in these things, the more
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effective bank lobbies are in weakening
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the fundamental regulations.
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So, what else is it important to know
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about Basil 3? Uh, well, that is it's a
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very complex package. Um, one thing
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they've already tried to do and it's
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clear they can't do it effectively is
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correct some of the risk weights. Um,
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one of the obvious mistakes they made
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was underestimating the riskiness of
00:20:50
very lowrated debt like subprime u or uh
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CMOS or C collateralized mortgage back
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obligations. Um, and so they tried to
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fix that um I guess about a year and a
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half ago uh because it was such an
00:21:05
obvious problem by doubling the risk
00:21:07
weight on it. And it took about oh I
00:21:10
don't know a month maybe five weeks for
00:21:14
investment bankers to figure out a way
00:21:15
around it. And because you can still
00:21:18
tanch things, uh, all you have to do is
00:21:20
create a new collateralized mortgage
00:21:22
back security. And sometimes they would
00:21:24
have it sort of guaranteed so that you
00:21:26
would, uh, recolateralize it again and
00:21:29
you could make enough of it AAA so that
00:21:32
even with the greatly increased risk
00:21:34
weights on the bottom piece, uh, you
00:21:36
could actually lower your capital
00:21:37
requirements. So, it's yet another
00:21:39
indication of just how um I think
00:21:42
misguided the whole notion is that they
00:21:44
can estimate risk with enough precision
00:21:46
to to have much of an impact. Um what
00:21:50
what might have been a better approach?
00:21:52
Uh I think in the end they're fooling
00:21:55
themselves that they think they can do a
00:21:57
lot better than a leverage ratio. uh you
00:21:59
can do some simple things like uh taking
00:22:02
government debt out or things that that
00:22:04
are perfectly safe but uh in some ways I
00:22:08
think Basel one had a closer it was it
00:22:12
had distortions in it we all knew what
00:22:14
they were uh but the distortions in
00:22:16
Basel 2 are so subtle that I don't think
00:22:20
that regulators will catch on to them
00:22:24
and external analysts will have trouble
00:22:27
tracking
00:22:28
In in Europe, there are actually 168
00:22:32
different implementation choices a bank
00:22:34
can make. So, you'll have no
00:22:37
idea how to compare them with another
00:22:39
bank that may have made different
00:22:41
choices. And with a lot of stuff coming
00:22:44
under pillar 2 that we just don't know
00:22:46
about, it's it's just very hard to know
00:22:48
whether a bank that seems to have a lot
00:22:50
of capital is very conservative or
00:22:54
whether the regulators are scared to
00:22:55
death and are causing them to hold more
00:22:57
capital. But the other new thing about
00:22:59
the Basel 3 requirements which isn't
00:23:03
yet implemented has to do with um
00:23:06
liquidity because one of the clear
00:23:08
things uh actually it was uh
00:23:10
overemphasized in my view was that
00:23:13
liquidity was a major problem in the
00:23:15
crisis. In fact, I think the regulators
00:23:18
wasted a whole year treating it like a
00:23:21
normal liquidity crisis when really as
00:23:24
early as as August or September of of
00:23:27
2007, it was obvious that a number of
00:23:29
banks were insolvent. But instead, the
00:23:32
regulators chose to flood the market
00:23:34
with
00:23:35
liquidity. And um so they've decided
00:23:37
that that banks need to be responsible
00:23:39
for more of their own liquidity. And
00:23:41
they're putting in two ratios for that.
00:23:43
Um, one of them is pretty clear. The
00:23:47
other one is sort of not ready for prime
00:23:49
time, but they wanted to have a
00:23:51
short-term ratio that would um enable a
00:23:55
bank to survive a severe stress test for
00:23:58
30 days. Well, they did a trial run of
00:24:01
it and um very few banks could survive
00:24:05
it. So, they now have a less severe
00:24:07
stress test. The banks are supposed to
00:24:09
meet with 30 days on on their own
00:24:11
liquidity. Um the other idea is to um
00:24:16
limit the dependence of banks on
00:24:18
wholesale funding. And so they have in
00:24:20
mind a sort of long-term ratio that um
00:24:24
they haven't really uh resolved yet.
00:24:27
It's a hard thing to do. It may not be
00:24:30
appropriate to do for every kind of
00:24:31
financial institution. So it's not clear
00:24:34
that's going to see the light of day.
00:24:37
Well, thanks very much. We really
00:24:38
appreciate you coming in today and uh
00:24:41
look forward to following up if there's
00:24:43
sounds like there may be a basil four in
00:24:44
our future with all these things left
00:24:46
undone. Well, it's not just that it's
00:24:49
you have independent regulatory actions
00:24:52
being undertaken by all the other major
00:24:53
players, not least of which is the
00:24:56
DoddFrank bill, which does not always
00:24:58
correspond of what Basil is doing and um
00:25:02
is turning out to be very very hard to
00:25:04
implement.
