A Battle over Basel II

A seven-year mission to make the world's banks more efficient runs into trouble.
Economist StaffNovember 10, 2006

For the world’s bankers, it has been the equivalent of seven years’ hard labour: since 1999 banks have been cajoled, at some cost to themselves, toward a new regulatory regime that will affect the all-important cushion of capital they hold to prevent a run on deposits.

So when Klaus-Peter Müller, the head of the Association of German Banks, issued a warning two months ago that Basel II, as the new framework is known, might fail, there was a note of despair in his voice. Since then things have got, if anything, worse.

Soon after Mr Müller’s gloomy warning came a Senate hearing in Washington, DC in late September. A succession of American bank regulators each cautioned against the sophisticated methods of Basel II unless they could also preserve a cruder measure of banks’ lending exposure, the leverage ratio. Introduced in America in 1991 in the wake of a housing-loans crisis, the leverage ratio ensures that a bank’s core capital is at least 3% of its balance sheet, whatever the quality of its loans and its risk-management systems.

The leverage ratio could now be exported to other jurisdictions too. Sheila Bair, chairman of America’s Federal Deposit Insurance Corporation, put it on the agenda at a recent meeting of the Basel Committee, the panel of rich-country regulators which devised the Basel rules, prompting what has been called euphemistically a “frank exchange of views.”

For Mr Müller and his fellow German bankers, who have spent fortunes on upgrading to the new Basel rules, mentioning a leverage ratio is like calling for the cat o’ nine tails. The Germans are not alone. Bank regulators in practically every country have been working on Basel II. They have devised a system for banks in about 100 countries to hold levels of capital that more closely reflect the actual risks borne by the bank in terms of the credit rating of borrowers, the exposure to derivatives and the volatility of securities. At the highest level, banks’ home-grown risk calculations are trusted to set the standard.

The European Union has gone as far as passing a Capital Requirements Directive which binds banks in member states by law to start complying with its version of Basel II, in stages, from January next year. Other places, such as Hong Kong, have written rulebooks that they will also begin implementing from next year.

By contrast, the four main American agencies which supervise banks finally posted a “notice of proposed rule-making” on September 25th. The notice, which triggered congressional hearings, says that Basel II, if and when the American version ever sees daylight, will be applied only to internationally active banks—around 26 at present. All other banks will be regulated by Basel 1A, which contains a few elements of Basel II, but retains the leverage ratio. Even the 26 banks readying for Basel II will be forced to cling to the leverage ratio as a safety measure.

Naturally, the big American banks are annoyed at having their wings clipped in this way. Big European banks are irritated too. First, because any American subsidiary they have will be subject to the same regime. Second, because they have invested millions in a risk-based system that was meant to be applied and harmonised worldwide—the Americans will not introduce their version of Basel II until 2009 at the earliest. Smaller European banks are annoyed because their American equivalents do not have to spend time and money complying with Basel II at all.

American banks with subsidiaries in jurisdictions applying Basel II will have to start complying there—which makes reconciliation with the numbers given to their American supervisors quite a challenge. Likewise American supervisors, luddite though they may be, have promised to help their foreign counterparts by inspecting the Basel II risk-calculation models used by foreign banks on their soil.

Since Basel II is being applied in stages anyway—full compliance in the EU is not due until 2008 and any capital reductions have a moving floor over three years—the American foot-dragging is not disastrous. Moreover, the collywobbles of the American regulators do have some basis.

Test runs on the possible effects of Basel II have suggested that some banks, particularly American ones, could slash their capital by 31%. That alarmed their regulators since Basel II was meant to reduce some banks’ capital cushions only marginally and increase others. But they should console themselves that they have flexibility under Basel II to reward or punish risk-management performance, as do the rating agencies. If they feel banks are letting go of too much capital, there is still plenty that they can do about it without resorting to the blunderbusses of the past.