In a press release on Sunday, September 12, the Basel Committee of Banking Supervision issued its road map for the modified international capital guidelines known informally as “Basel III.” At its heart, the three stage evolution of international capital guidelines from Basel I to II to III have been based on two premises: that banking is an international business, therefore regulations should be world-wide, and that regulations regarding risk in banking should be “rules based” rather than “principles based.” Sadly, both of these premises are wrong, and Basel III illustrates the first steps toward returning to “principles based” regulation by the Basel Committee on Banking Supervision. We believe the Basel Committee is coming to the conclusion that rules based “Risk Management by Excel” is not sufficient regulation of risk in banking.
Let’s start first by asking a simple question. Why are there capital rules on banks but not on fast food restaurants? The reason is equally simple. Governments step in to bail out depositors of failed banks, and they sometimes bail out the full range of liability holders through common stock holders (e.g. Royal Bank of Scotland, Citigroup, Bank of America). They don’t extend such largess to fast food restaurants. As a quid pro quo for this quasi liability insurance, most governments charge a fee for deposit insurance that rarely distinguishes between high risk banks and low risk banks. Instead, governments impose constraints on risk taking rather than measuring risk precisely and charging more for it.
There are two ways to impose constraints on risk taking. The first way, “rules based regulation,” specifies the exact financial formulas by which risk is measured. If measured risk exceeds the regulatory level of X, the bank is in violation. The second method of regulation is called “principles based regulation.” It combines a qualitative and quantitative assessment of a bank’s risk level and risk management process. It asks questions like “Has the bank taken the risk of declining home prices into account in assessing its own risk?”
Politicians, who have just spent the taxpayers’ money to bail out failed banks, supported by regulators whose salaries they pay, love rules based regulation because it imposes a more concrete “punishment” on the banks that have just failed and those that will fail in the future. Unfortunately, this approach has been tried repeatedly and has failed consistently. In the United States, the process has gone like this:
- Mid 1980s. Federal Reserve imposes “primary capital ratios,” a rules based regulation, in the wake of high interest rates and related bank and savings and loan association losses
- 1992. Federal Reserve seeks to impose a more precise formula linking interest rate risk to required capital, a more complex rules-based regulation. This proposal was opposed by bankers and later by Congress as too complex and was never implemented.
- 1998. The Office of Thrift Supervision imposes principles based regulation via “Thrift Bulletin 13a” which indicates areas of risk and highlights those elements of interest rate risk management that will receive a high level of regulatory scrutiny.
The Basel Committee on Banking Supervision is repeating this three stage process in the wake of the Russian debt crisis in 1998, the collapse of the high tech boom in 2001-2002, and the current credit crisis of 2007-2010.
- Basel I was a highly simplified rules based capital ratio constraint which closely resembled the Federal Reserve’s primary capital rules
- Basel II was a much more complex rules based regulation spanning hundreds of pages and triggering billions of dollars of implementation costs. Basel II is widely regarded as a complete failure in the wake of the collapse of a large number of banks in Europe and the United States during the 2007-2010 period
- Basel III represents a potential simplification of the Basel II rules and hints at a return to a stronger emphasis on principles based regulation in conjunction with a simpler capital regulation. At least one hopes so.
The seven page press release from the BIS on September 12 only forecasts at what is to come from Basel III. The time line looks like this:
We believe firmly that risk management of financial institutions and oversight of that risk by regulators is too complex for “Risk Management by Excel” to be the standard. Effective risk oversight recognizes these realities:
- The Devil is in the Details. Risk should be analyzed on a transaction level basis, one by one, spanning even the 700 million transactions held by the largest banks in China.
- Risk should recognize the potential adverse affects of a long list of true causes of risk: movements in home prices, commercial real estate prices, commodity prices, correlated corporate credit risk, stock indices, and other factors along with traditional areas of focus like interest rate risk and foreign exchange risk
- Best practice analysis of this risk cannot be fully specified in a 7 page press release or even the 300 plus pages of the original Basel II pronouncements. Attempts to do so are complete folly.
- Rules based regulations are constrained by the ability of non-specialist bankers, regulators and politicians to understand them. This leads either to a collapse of the attempted regulation, like the Fed’s proposed interest rate rules, or a dramatic simplification like the Basel III. This simplification creates “Risk Management by Excel” and triggers gross inaccuracies.
- Only principles based regulation is ultimately effective in bringing highly accurate transaction level analysis to regulators and bank management. This takes technology and smarts on the part of regulators and banks.
- When the national political will does not provide the technology and smarts to regulators, the only alternative is the kind of limited purpose banking regulations proposed by Professor Laurence Kotlikoff in Jimmy Stewart is Dead: Ending the World’s Financial Plague with Limited Purpose Banking (2010).
- Principles based regulation and limited purpose banking are by definition intimately intertwined with national culture, domestic banking practice, and regulatory organization. We note that more than 99% of banking assets in almost every major country (we exclude international banking centers like Singapore and Bermuda) are domestic. One would conclude, then, that the role of Basel in principles based regulation is less than useful. “One world” in banking regulation is a concept whose time has not yet come.
Donald R. van Deventer and Eitan Bar-Adam
September 15, 2010