Fin Reg Goes International

While Congress rounded out its last day of recess on Sunday, regulators it empowered to strengthen our financial system concluded an international agreement to put tough new restrictions on banks. The Basel III agreement -- named after the Swiss city that hosts the Bank of International Settlements, the institutional home of global financial coordination -- fulfilled the Obama administration's vision for overhauled bank regulation and demonstrated impressive clout abroad.

"One can only conclude from this outcome that the U.S. regulators were quite aggressive and that they were able to have certain disproportionate influence over the outcome," says Raj Date, who heads the reform-minded Cambridge Winter Center on Financial Policy. "Both of those things are good news."

Flash back to the financial crisis: In 2008, American regulators enforced a modified version of Basel II, the last international agreement on bank standards. Under that agreement, banks were required to monitor the ratio of how much hard capital they held to their total assets, expressed as a percent. This capital ratio had to be greater than 2 percent, so (roughly) for every hundred dollars in assets, banks needed to have $2 of capital on hand. Banks had to hold another class of capital, too, but with a wider definition: Some securities -- including subprime-mortgage instruments -- were considered as good as cash. Meanwhile, some assets, like over-the-counter derivatives and credit lines that clients hadn't accessed yet, weren't fully included as costs on the asset side of the ratio.

When the market crashed, the limits of those standards became apparent: Suddenly, reserves were worthless. Liabilities increased as debts that hadn't been counted in the ratio were called in. Banks across the financial system were on the brink of becoming insolvent; some, like Bear Stearns, Lehman Brothers, and Wachovia, simply failed. In response, the U.S. government backstopped banks with public money until they, and the economy, could recover.

As the Obama administration and federal regulators sat down to figure out what regulations could prevent future crises, increasing capital requirements was at the top of its list. Asked in 2009 how he would address the problem of "too big to fail" banks, Treasury Secretary Timothy Geithner replied, "The most simple way to frame it is capital, capital, capital. Capital sets the amount of risk you can take overall. Capital assures you have big enough cushions to absorb extreme shocks."

Not only would forcing banks to carry greater reserves decrease the likelihood of the need for another government bailout; it would limit the amount of risk they could take trading while increasing their incentives to lend. As a rule, bankers don't like to carry as much capital as public interest suggests they should, so not only would increasing requirements be a fight; it would also have to involve international consensus to prevent any one country from maintaining loose rules and gaining a systemically risky advantage over other countries.

The Dodd-Frank financial-reform bill that passed this past summer, then, included provisions calling for higher capital standards but not a clear idea of what they would be, leaving the specifics up to the regulators in Basel. Critics fretted that during the regulatory process, the financial sector would convince often-amenable regulators to create lax rules.

Not this time. On Sunday, when the Basel Committee, which includes Federal Reserve Chair Ben Bernanke, voted to approve a new global capital regime, the capital requirement more than doubled, to 7 percent. That includes a 2.5 percent "capital cushion," where banks that don't meet the 7 percent standard cannot issue dividends or take other steps that decrease their reserves. A broader category of capital, called "Tier1," now has a stricter definition and will bring total bank reserves up to 10.5 percent of assets.

Experts and a U.S. official familiar with the agreement also point to improvements in how the risks of different assets are now calculated to create a more realistic sense of how valuable they will be during a crisis. More stringent accounting of both potential losses and capital, combined with the higher ratios, will create a substantially stronger system over the next five years, the U.S. official says.

That time period, though, points to a setback in the Basel negotiations. While American representatives were reportedly pushing for quicker adoption of the standards (thanks to TARP and the stress tests, many American banks have recapitalized faster than their international counterparts). German bankers, along with other European and Asian representatives, were skeptical both about tighter definitions of capital and how quickly to implement the changes. That led to the six-year implementation period, beginning in 2013, rather than adopting the new rules at a quicker pace.

Another compromise was on "countercyclical capital," the idea that in boom times, banks should carry extra capital reserves, up to 2.5 percent more, in anticipation of slumps and to deter asset bubbles. However, the optimism accompanying a growing economy makes it very difficult for regulators to mandate such measures. While Basel III endorses the idea of countercyclical capital, it relegates implementation of the idea to individual jurisdictions, and it's difficult to imagine one country's regulators jacking up capital requirements as the economy grows if competing regulators decline to join.

American regulators nonetheless welcomed Basel III, which is largely in-line with the Dodd-Frank financial reforms, even as bankers complain, mostly baselessly, about the cost of these new restrictions. While critics of the financial-reform bill abound, believing it gives too much discretion to regulators and does not take enough drastic action to cut banks down to size, most reformers see the new Basel accord as a strong first step forward, provided it is executed well.

The Dodd-Frank bill mandates that the largest, riskiest institutions -- think Goldman Sachs, Bank of America, and JPMorgan -- have even tougher capital standards than those considered the baseline for the financial sector. Regulators will now have to decide whether Basel III is the ceiling -- smaller American banks never even came under enforcement of Basel II -- or the floor; a strong system would make it the floor. In Switzerland, they'll add an extra set of tough rules on top of Basel, a so-called Swiss finish. We could use the same kind of strict attention in the United States as the new standards are implemented.

Regulatory discretion was both the theme of the Dodd-Frank bill and the primary criticism against it -- while worries about regulatory capture are real, the idea that the government can supervise the financial sector without regulators having serious influence is unrealistic. Over the past few months, our regulators, particularly those supervised by Fed Governor Daniel Tarullo, have been abroad exercising the discretion Congress awarded them. They've come back with a tough new international regime, a rare sign of optimism in the battle with the banks.

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