The Battle Over Bank Rules at Basel III

A week before the Senate passed legislation to overhaul the banking industry, Michel Barnier, the EU's financial-services commissioner, was in Washington eating scones and sipping coffee with Treasury Secretary Timothy F. Geithner. On the agenda was an issue that may have an even greater global impact than the reform bill: new international rules being considered by the Basel Committee on Banking Supervision.

The Barnier-Geithner meeting is evidence of the growing role of politicians in setting global banking rules. The 36-year-old Basel committee, made up of central bankers and regulators from 27 countries, is responsible for setting international bank capital standards—essentially, the reserve a bank must hold as a buffer against losses, which affects how much money it can risk in the markets. According to an estimate by UBS, banks may need to raise $375 billion of fresh capital to comply with the new rules. JPMorgan Chase (JPM) predicted in February that the rules would cut annual earnings at 13 of the largest banks by $20 billion.

The committee has circulated preliminary proposals and is now evaluating comments on them from banks and government officials. It plans to publish final rules by December; it will then be up to individual nations to adopt them.

An earlier revision, known as Basel II, was initiated by lenders in the late 1990s during an era of deregulation. Basel II lowered capital requirements by as much as 29 percent for some banks, according to a 2006 study by the Basel committee. Now, following the worst financial crisis in more than 70 years, the process is being driven by politicians, and bankers may have less influence, members of the committee and bank lobbyists say. "Governments have realized they need to be more involved in the capital standards of their banks," says V. Gerard Comizio, a former Treasury Dept. lawyer, now a partner at Paul, Hastings, Janofsky & Walker in Washington.

The Basel committee doesn't disclose the names of its members, publish minutes, or have a press officer. It gathers four times a year around an oval table in Meeting Room D on the first floor of a round, 20-story glass tower in Basel, Switzerland, according to one former participant. A request for a list of people attending meetings of the committee and more than a dozen subcommittees was turned down. "I don't think they've ever given those names," says Lisa Weekes, a spokeswoman for the Bank for International Settlements, which is housed in the same tower and provides support services for the Basel committee. The members who spoke to Bloomberg asked not to be identified.

The rules put forth under Basel II represented a paradigm shift: Instead of relying on standardized formulas, they allowed the largest banks to use internal models to calculate the risks of their assets to determine the capital charges against them. The drawbacks of that approach became clear during the credit crisis, when many banks found they did not have the financial strength to withstand the losses on investments that proved to be much riskier than the models suggested.

This round of changes, known as Basel III, was spurred by leaders of the G-20 nations, representing the world's major economies, who urged at meetings in April and September last year that the committee strengthen guidelines to improve bank safety and discourage excessive risk-taking.

While the new rules will continue to rely on banks' risk models, the committee has proposed tighter control of what goes into those calculations, a narrower definition of what counts as capital, and a requirement for banks to set aside extra money when they hold certain riskier assets. It also may impose a cap on the amount of assets a bank can have in relation to its equity and require banks to have enough cash to meet short-term liabilities.

"Basel III will be a very different animal," says Charles Goodhart, a former Bank of England policymaker and professor emeritus at the London School of Economics. "We can say with conviction now that Basel II failed. It led to a relaxing of capital minimums. Regulators now understand the lessons and are trying to fix the problems."

Banks in the U.S. and Europe are resisting some of the proposals. French and German banks have objected that the rules would have a disproportionate impact on European banks because European companies rely more on traditional bank loans for funding than their American counterparts, which are more likely to raise money in the capital markets. U.S. bankers complain that the new definitions of capital do not count certain securities used only by U.S. banks.

"There's a balancing act that the politicians need to play between making the system really safe and keeping it relevant," says Mark Flannery, a finance professor at the University of Florida in Gainesville who has tracked Basel for two decades. "If you restrict the banks too much, financial activity will be curtailed or it will shift to nonbanking institutions, making the rules irrelevant."

No matter how carefully constructed the new rules are, lenders may find ways around them, says Joseph Mason, a professor of finance at Louisiana State University in Baton Rouge: "Wall Street will always have more lawyers and more accountants and more brains than the regulators."

The bottom line: Higher capital requirements may cut bank profits, but they will help the system withstand the withering losses that led to the credit crisis.

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