Basel III: Some costs will outweigh the benefits

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Article Highlights

  • Basel III is just too complex.

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  • Higher capital levels required by Basel III will pose a problem for small banks.

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  • Basel III will prove ineffective for controlling large bank risk.

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The new Basel III regulations will require significantly higher minimum capital levels for banks and bank holding companies. Although many applaud higher capital levels for large institutions, it is unclear that there are good economic reasons to apply these rules to small banks. Beyond the well-known capital increase, Basel III contains new unproven macroprudential capital buffers that will impose costs on large banks with uncertain stability benefits. The complexity of the new Basel III rules give rise to a host of concerns. Complex rules are difficult and expensive to enforce. The new rules will place even greater burdens on the interpretation and judgment skills of front-line bank examiners, and evidence already exists that this will be problematic. Moreover, history shows that when bank supervisors are preoccupied with writing and interpreting complex capital regulations, they often miss emerging financial-sector imbalances. Future bank regulations should be developed with a greater appreciation for the practical limits on verification. They should be less complex and more transparently enforced.      

Key Points in this Outlook:

  • Community banks will face large costs under Basel III, yet there is no compelling financial stability reason to require Basel III for community banks.
  • The benefits of Basel III’s new countercyclical capital buffer are unproven. It will impose significant costs on the industry, and its governance lacks transparency.
  • Basel III rules are far too complex to be effectively implemented. 
  • In time, Basel III will prove ineffective for controlling large bank risk. The next generation of capital regulation should be targeted to improve transparency, reduce complexity, and recognize practical limits to verification.

 

Basel III is a new set of regulations that will determine the minimum levels of capital for banks and bank holding companies. It is essentially a very detailed rulebook for setting the minimum regulatory capital requirements for internationally active banks. 

The Basel III “headline” is that it raises the capital requirements the largest institutions must satisfy. The new rules are often described as raising the level and the quality of the capital that banks must maintain as buffers against potential losses.[1]

While the headline is true, unfortunately, Basel III does not stop there. The “fine print” behind the headlines makes a formidable reading assignment. The new complex regulations include business cycle-dependent capital surcharges, minimum liquidity rules, a systemically important financial institution leverage ratio surcharge, and many additional requirements that were needed to plug loopholes in the prior Basel II market and trading book rules that became apparent in the recent financial crisis.

Basel III is not an international treaty, and it is not approved or even reviewed by the US Congress. The federal banking agencies[2] represent the United States on the Basel Committee on Bank Supervision, and they have negotiated the Basel III rules and agreed to apply them to appropriate US institutions.[3]

In the United States, three federal bank supervisory agencies are responsible for setting capital requirements for the depository institutions they supervise, and the Federal Reserve sets capital requirements for bank holding companies. The Wall Street Reform and Consumer Protection Act of 2010 (the Dodd-Frank Act, or DFA) requires the bank supervisory agencies to impose enhanced capital regulations for the largest banking institutions and, when possible, to harmonize US regulations with international standards. In July, the banking agencies issued their notice of proposed rule-making (NPR) to satisfy DFA requirements and implement Basel III.

The new Basel III rules are very complex. They span almost 1,000 pages, not including 219 pages of new market risk rules issued in July 2012 or 40 pages of leverage ratio rules for the largest institutions. Regulators argue that the complexity of bank capital regulations is necessary to counteract bank strategies that reduce regulatory capital requirements and increase leverage. 

"Despite the length and complexity of these new regulations, they still give an incomplete accounting of some important sources of bank risk"

In discussing Basel III, it is important to note that, despite the length and complexity of these new regulations, they still give an incomplete accounting of some important sources of bank risk. For example, credit risk concentrations—a risk the official Basel II 2006 document calls “arguably the single most important cause of major problems in banks”—are not addressed in Basel III.[4] Concentration risk has been closely linked with the recent wave of bank failures.[5] In a period of ultra-low interest rates (which are bound to rise), Basel III does not include capital requirements for interest rate risk. Basel III also still allows national regulators to treat their sovereign bonds as if they are riskless—which is at odds with the recent experience for Greek and Cypriot banks and for Argentine banks a dozen years earlier. 

Even if internationally active banks fully comply with the provisions of Basel III and operate with the same Basel III capital ratios, their true risk potential will still differ markedly depending on the credit risk of their home country sovereign’s bonds, individual bank credit risk concentrations, and the interest rate risk of their overall positions. The standard response to recognizing these omissions is that national regulators always have the right to require capital for these additional risks, should they choose to do so (the so-called Basel Pillar 2). Although technically true, there is little evidence that this systematically happens among the countries that have adopted the Basel Accords.

In this Outlook, I will discuss three important issues related to the US implementation of Basel III that are often overlooked in headline coverage: its impact on small community banks, the difficulties involved in implementing such a complex set of regulations, and how bank supervisors’ focus on these complex capital rules has, in the past, distorted their analysis of underlying trends that were critical for financial stability. 

Basel III Is Overkill for Community Banks

The DFA does not include any provisions that require the bank supervisory agencies to change the capital regulations that apply to small banking institutions, yet the banking agencies decided to adopt Basel III capital rules for all banks, including community banks. The US implementation of Basel III gives relief for small banks in some important areas, but it still applies higher capital requirements and higher prompt corrective action thresholds to small institutions. 

Most small banks already meet Basel III Tier 1 capital requirements. This is true in part because small banks have chosen to retain much higher capital ratios than the largest institutions. One important reason small banks hold large capital buffers above regulatory minimum requirements is because they face higher issuance costs should they unexpectedly need to raise new capital.[6] If bank managers and investors deem it necessary for community banks to continue to maintain a capital buffer above minimum regulatory requirements (also called market discipline), then many small banks will be forced to raise additional capital under Basel III.

Many small banks are organized as subchapter S corporations where the bank’s income is not subject to corporate income taxes but instead is recognized as income on the bank owners’ personal tax returns. Subchapter S corporations must have fewer than 100 equity owners. Similar to partnerships, subchapter S bank income, deductions, and tax credits flow through to shareholders in proportion to ownership shares. The bank’s income must be recognized by its owners regardless of whether the bank distributes any cash dividends. As of June 2013, 2,239 institutions—or about one-third of all depository institutions—were organized as subchapter S corporations.

The higher Basel III capital requirements and the newly introduced Basel III capital conservation buffer raises new issues for bank subchapter S owners. Once the rules are fully phased in, if a bank’s Tier 1 common equity capital ratio falls below 8.5 percent, the bank will face restrictions on its ability to make dividend payments. Basel III will increase the likelihood that subchapter S bank owners could face a tax liability without a cash dividend offset. Although this can happen under the current capital rules, the introduction of the Basel III capital conservation buffer heightens the risk that bank subchapter S owners could face an unfunded tax liability on their ownership shares.[7]

"Why put further restrictions on bank entry in the form of new complex regulations and higher required capital levels when there is no financial sector stability need for new regulations?"

Why are any of these Basel III changes needed for community banks? Since the Federal Deposit Insurance Corporation began operating in 1934, the United States has had a system where most banking institutions—all but the very largest—can exit the market with minimal economic harm to other institutions or to the economy. Small community banks can—and unfortunately do—fail, but the world goes on without a “systemic financial crisis.” Why then put further restrictions on bank entry in the form of new complex regulations and higher required capital levels when there is no financial sector stability need for new regulations? 

The current system of capital requirements and supervisory powers is completely adequate for supervising small banks, provided supervisors sensibly exercise these powers. The recent wave of small-bank failures represents fallout from the financial crisis; many small banks’ losses were generated by the undertow of economic collapse following the implosion of the subprime bubble. 

Although an argument could be made that aggressive community bank lending contributed to the bubble in the Southeast, even there, any contributions were still relatively small and controllable had supervisors been more proactive with their existing powers. It is difficult to imagine a sensible social cost-benefit analysis that would argue for imposing the complexity and higher capital requirements of Basel III on small banking institutions.

Basel III Introduces Unproven Macroprudential Bank Regulations

The current system of prudential bank regulations focuses on maintaining the safety and soundness of individual depository institutions. This style of regulation has become known as microprudential regulation. 

Some economists have argued that microprudential regulations create externalities that reduce financial stability and economic growth. For example, some argue that when banks face losses that threaten their regulatory capital adequacy, they shrink their lending rather than raising new capital, and thereby reduce economic growth.[8] Or if banks face a severe draw on liquidity, they react by selling assets and depressing market prices, causing mark-to-market losses for other institutions that may be forced to respond by selling assets or limiting lending. 

So-called macroprudential regulations are supposed to modify traditional safety and soundness regulations in ways that minimize the spillover effects that traditional regulations may cause in a crisis. One possible interpretation of section 171(7)(A) of the DFA is that it implicitly requires the adoption of macroprudential capital regulation.[9]

The Bank of Spain was one of the first bank supervisors to modify microprudential regulations to limit spillover effects. It implemented rules that required banks to build up special loan loss provision accounts in good times that do not count as regulatory capital. During bad times, banks are allowed to draw down these accounts to augment their capital. This scheme has been in effect in Spain since 2000. Given the depth of Spain’s financial crisis, it is difficult to argue that these rules have had an important stabilizing effect.

The macroprudential theories that influenced Basel III were recently developed by economists who are attempting to model the dynamics of a financial crisis. Regulatory officials who faced political mandates under short deadlines to reform regulations and fix the financial system have embraced these theories notwithstanding the fact that they are very new, untested, and perhaps even ineffective if one takes Spain’s experience as relevant. Still, the theories have been incorporated into Basel III under the justification that they are needed to offset the negative “procyclical” effects of risk-based capital regulations on bank lending. 

For large banks, Basel III includes a new countercyclical capital buffer that can change by as much as 2.5 percentage points over the course of the business cycle. This feature has been the focus of much discussion within the Basel Committee itself but has not been extensively debated in public discussions about US Basel III implementation. The Basel Committee guidelines favor a trigger based on macroeconomic indicators: when credit growth is strong (or weak), capital requirements should be high (or low). But in the international discussions among regulators, policy execution risk was never given due consideration. Theories (and regulators) usually assume that the macroprudential levers will be moved the right amount at the right time, but in reality this almost never happens. 

"The current rules for Basel III implementation are vague on the processes US regulators will use to decide where to set the lever that controls the Basel III countercyclical buffer."

The current rules for Basel III implementation are vague on the processes US regulators will use to decide where to set the lever that controls the Basel III countercyclical buffer. Exactly who owns the on-off switch and the responsibility for setting the magnitude of countercyclical capital buffer? The banking agency implementation notice indicates that the buffer setting will be a joint decision of the banking agencies but offers few additional specifics.

The countercyclical capital buffer can move capital requirements as much as 2.5 percentage points—not an insignificant amount. It is also important to realize that raising new additional capital will impose significant issuance and adjustment costs on the banks required to meet this new buffer. Issuance and adjustment costs are transactions costs associated with marketing new capital issues or changing payout policies. They are fully present in the real world and are nontrivial even when the Modigliani-Miller bank cost of capital relationship holds in the long run.[10]

The rules governing the Basel III countercyclical capital buffer seem especially odd in that they exclude any direct role for the Financial Stability Oversight Council in the decision process for setting a regulation that is supposed to have an important impact on financial stability. This issue merits much more public attention. If this buffer has important economic effects, then the processes surrounding its use should be more transparent and responsible decision makers should be subject to some standard of accountability. If it does not have important economic effects, then why adopt it? 

Basel III Is Just Too Complex

Basel III was created to plug loopholes in the prior Basel rules that large international institutions were exploiting. Once the Basel rules were reopened, many new, unproven, and complex features were added to the regulations. The truth about Basel III is that no one is really sure if any of the additional complexities will work, and each brings additional costs and risks. 

The most obvious costs of Basel III include large direct bank compliance costs. The less immediate costs of Basel III will be the indirect social costs that arise when these rules skew bank investment decisions away from otherwise sound economic investments into favored investment classes where Basel III risk-weighting understates the true risks. Although it will take time for these risks to materialize, they are real and costly. Recall that the Basel II capital regulations badly miscalculated the capital needed for securitized assets and banks responded by securitizing their risks, which lowered their required capital without lowering their risks. Perhaps the most important but least discussed risk created by Basel III is the risk that the new rules will degrade the quality of supervision and end up reducing financial stability. Common sense suggests that complex rules are likely to be difficult and expensive to enforce. Basel III is by far the most complex set of bank regulations that have ever been attempted.

Experienced bank frontline supervisors will tell you that simple “bright line” rules are the most easily understood and enforced. Regulations more like the US leverage ratio and less like Basel III are preferred on basis of simplicity and transparency. Regulations that use quantities that can be accurately and objectively measured and used to require well-defined ratios or minimum coverage levels are difficult to game. 

And even when regulatory rules are simple, difficulties still remain. For example, even a basic leverage ratio—bank book equity to book assets—can be the subject of bank-supervisor controversy. Banks and supervisors often argue about the adequacy of bank loan loss provision and thus the “true” book value of a bank’s assets and equity. Still, for frontline US bank supervisors, judging the adequacy of bank loan loss provisions is second nature and part of the normal loan review process. Not so for European bank supervisors who rely on accountants to verify banks’ provisions, often without any independent supervisory review. 

Now change the simple process described here—make examiners assess the ratio of bank book equity to risk-weighted assets—and the verification process gets much more difficult. For the largest banks, so-called advanced-approach banks, Basel III risk weights are set using the bank’s internal models that classify loans into internal credit grades, each of which has an associated bank estimate of projected default and loss performance. Many complex issues now arise. Are the loans assigned to the right buckets? How can one tell? Does the bank have historical data to support its projections of default and loss rates for each of its risk buckets? Are the data the bank is using taken from a period that included a recession, or were they cherry-picked to include only profitable years? Are the statistical and econometric methods used to make the estimates accurate and appropriate? 

"Future revisions to bank minimum capital regulations should be targeted to improve transparency, reduce complexity, and recognize the practical limits to verification."

Banks’ historical data and modeling accuracy often are suspect, but an examiner must still arrive at a judgment as to whether a bank’s estimates are “good enough” to satisfy the capital regulations. Many of these judgments are difficult even for PhD statisticians and econometricians, so it is not surprising that frontline bank supervisors have difficulties enforcing such a complex standard. 

When the rules are as complex as Basel III, while the rules look prescriptive, in reality the veracity of the rules depends more than ever on interpretation and judgment of the examiners evaluating rule compliance. A recent real case study substantiates the gravity of this issue. 

Recently, two different federal bank supervisory agencies examined an institution. One supervised the bank holding company (BHC) and the other the depository institution (bank). The BHC and bank were both large enough to require supervisory approval to use the new Basel market risk rules for their trading books. These rules allow the institution to use its internal risk models to determine capital requirements for trading activities, provided that the institution’s models and systems meet minimum regulatory standards. 

The supervisors conducted independent assessments of the institution’s market risk models and measurement systems. One supervisory agency approved the institution’s application to use internal models for its trading book capital requirements, while the other agency found that the institution did not satisfy any of the regulatory requirements needed to use its internal models. Moreover, the market risk measurement system used by the bank and the BHC were exactly the same—same data, same models, same individuals. 

Complex Capital Regulations Mask the Big Picture

When regulations are complex, banks need to employ nuanced interpretation and creative approaches for implementation. When it comes to nuance and creativity, large banks dominate supervisory agencies. Once creative regulatory compliance solutions are identified, virtually all the large banks adopt them. Once supervisors identify these trends—and often it takes a while for all three banking agencies to do so—bank regulators then debate among themselves whether these creative solutions raise issues of concern. In the process, often the industry successfully convinces regulators not to worry. A good example of this dynamic is the “Credit Risk Transfer” project undertaken by the Committee for Global Financial Stability (later renamed the Financial Stability Board) prior to the financial crisis.[11] 

History suggests that bank regulators all too often react to regulatory arbitrage by justifying the complex rules they have written rather than anticipating the economic dislocations that may be building as a consequence of the arbitrage. Recall bank supervisors’ claims before the financial crisis that the originate-to-distribute model of mortgage lending made banks safer and provided improved credit access to credit-constrained consumers.[12] Or supervisory explanations that the huge increase in bank issuance of structured credit and structured credit derivatives made banks safer by improving risk management and allowing banks to transfer credit risk to investors better positioned to manage the risk.[13] Both stories proved to be inaccurate, but the group-think organized around the banking agencies’ defense of the existing regulations discouraged supervisors and economists from undertaking different analyses that might have helped to identify the true underlying risks building in the economy. 

Today, many large banks have reacted to tighter capital regulation by “optimizing” their internal models to produce lower risk weights and lower minimum capital requirements. If banks can make arguments and build models that assign loans to safer buckets, their risk weights are reduced and their required level of equity capital declines. Perhaps less well known, but recent reports suggest that banks are lowering their risk weights by engaging in so-called “credit-relief trades” with hedge funds. In transactions similar to the credit risk protection business that brought down AIG in 2008, banks are buying credit risk insurance from hedge funds to reduce their regulatory capital requirements. 

Securitization and off-balance-sheet special investment vehicles were the favored way to reduce bank capital requirements and increase bank leverage before the crisis, and this practice ended badly. Perhaps these new credit-relief trade strategies are fully compatible with the new complex bank capital rules. But will it end better this time? Those writing the policy rules need to reallocate their time away from writing complicated regulations and toward analysis that identifies the potential economic implications of the strategies the largest banks are following. 

Complex capital regulations may give the appearance of rigor, but in reality they will fall short if they cannot be enforced. Basel III is just too complex to be effectively enforced, no matter how talented the bank examination force. 

Some sensible policymakers have begun to question the benefits of complex regulations and are arguing for reforms to reduce the complexity of regulatory capital rules. This initiative must be encouraged as it must overcome massive inertia generated by the industry and regulatory investments that have been made in the current approach. Future revisions to bank minimum capital regulations should be targeted to improve transparency, reduce complexity, and recognize the practical limits to verification.

Notes

1. The highest-quality capital recognized by the regulations is called “common equity tier 1,” which includes common shareholder equity, retained earnings, and accumulated other comprehensive income after some regulatory adjustments. This new Basel III definition for bank capital improves the quality of capital by eliminating banks’ ability to count hybrid debt instruments and the value of book assets that represent future tax deductions as capital.

2. These are the Federal Reserve Board, the Office of the Comptroller of the Currency, and the Federal Deposit Insurance Corporation. The Federal Reserve Bank of New York is also a US representative on the Basel Committee on Banking Supervision.

3. The international agreement on scope appears in the Basel II text. See Basel Committee on Banking Supervision, International Convergence of Capital Measurement and Capital Standards: A Revised Framework, Comprehensive Version (Basel, Switzerland: Bank for Inter-national Settlements, June 2006), 7, www.bis.org/publ/bcbs128a.pdf.

4. Ibid., paragraph 770.

5. Many studies of the recent financial crisis find that concentration in commercial real estate lending, primarily in construction and development loans, were an important factor contributing to the failure of many small banking institutions. See, for example, Government Accountability Office, Financial Institutions: Causes and Consequences of Recent Bank Failures, January 2013, www.gao.gov/products/GAO-13-71; and Rebel Cole and Lawrence White, “Déjà Vu All Over Again: The Causes of U.S. Commercial Bank Failures This Time Around,” Journal of Financial Services Research 42, no. 1 (October 2012): 5–29.

6. The GAO study on hybrid capital instruments discusses the issues small bank face in accessing new capital. See US Government Accountability Office, Dodd-Frank Act: Hybrid Capital Instruments and Small Institution Access to Capital, January 2012, www.gao.gov/assets/590/587759.pdf.

7. See Jackie Stewart, “Basel III Creating Headaches for S Corp Banks,” American Banker, September 30, 2013, www.americanbanker.com/issues/178_189/basel-iii-creating-headaches-for-s-corp-banks-1062488-1.html.

8. Such an occurrence is often described as a “credit crunch,” and the large literature investigating this phenomenon includes many empirical studies with conflicting conclusions. 

9. This DFA subsection states: “Subject to the recommendations of the Council, in accordance with section 120, the Federal banking agencies shall develop capital requirements applicable to insured depository institutions, depository institution holding companies, and nonbank financial companies supervised by the Board of Governors that address the risks that the activities of such institutions pose, not only to the institution engaging in the activity, but to other public and private stakeholders in the event of adverse performance, disruption, or failure of the institution or the activity.”

10. The famous 1958 Modigliani-Miller (MM) theorem states that the firm’s cost of capital depends on its asset risk and is independent of how the firm is financed. The theorem is true provided many stylized assumptions are satisfied. In practice, many of these assumptions are violated in banking, yet MM provides a useful framework to analyze bank cost of capital. See Franco Modigliani and Merton H. Miller, “The Cost of Capital, Corporation Finance and the Theory of Investment,” American Economic Review 48, no. 3 (June 1958): 261–97.

11. See Committee on the Global Financial System, Credit Risk Transfer (Basel, Switzerland: Bank for International Settlements, January 2003), www.bis.org/publ/cgfs20.htm.

12. See, for example, Comptroller of the Currency Administrator of National Banks, Asset Securitization: Comptroller’s Handbook, November 1997, www.occ.treas.gov/publications/publications-by-type/comptrollers-handbook/assetsec.pdf.

13. See, for example, Michael S. Gibson, “Credit Derivatives and Risk Management,” Federal Reserve Bank of Atlanta Economic Review 92, no. 4 (2007), www.frbatlanta.org/filelegacydocs/erq407_gibson.pdf.

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