After Basel, the Banks Are Not Safer

The Americans wanted tough rules, fast. The Germans pushed back. The British, Swiss, Japanese, and French joined the fray.

It's rare that international regulatory talks command such attention, let alone passion. Yet for once global bank reform is center stage. The Basel Committee on Banking Supervision, made up of bank supervisors and central bankers from 27 countries, has struggled in the Swiss offices of the Bank for International Settlements to construct new rules of the road for a global banking industry that is just staggering out of the wreckage of the 2008 crisis. The rules they have devised could prevent another crisis or unwittingly set the stage for one.

The results, reached on Sept. 12, were new capital and liquidity rules that satisfy few. The committee set standards many banks will find hard to meet. Yet banks have up to eight years to comply with most of them and as long as 13 years for some. "They missed an opportunity to strengthen the banking system quickly," says Jeremy I. Stein, an economics professor at Harvard University and a former adviser to the U.S. Treasury Dept. "Before these implementation deadlines arrive, we'll probably have another crisis."

When the talks to tighten bank regulations started last year, central bankers and bank supervisors had to construct rules tough enough to prevent another financial crisis yet flexible enough not to strangle the banks. The main task was to increase banks' capital requirements. Those are the funds set aside by a bank to provide a buffer against the possibility that its assets lose some or all their value in a crisis. Here the Basel committee showed some backbone. It tripled the minimum capital a bank must hold in the form of common equity and boosted the share of capital a bank must hold in the form of preferred stock.

Banks' Argument Prevails

The banks, however, secured a long phase-in period with a powerful argument: Too much pressure on them to build up a capital cushion would curtail lending. That's because a bank can increase its capital ratio—the size of the safety buffer compared with all it assets—in two ways. It can sell more stock to increase the numerator of the ratio, or it can cut lending to reduce the denominator. When the Basel committee gave banks four years to comply with its first worldwide capital standards in 1988, many reduced lending, which caused a credit crunch.

Committee members didn't want to repeat that mistake, says Joseph R. Mason, a former bank regulator who teaches finance at Louisiana State University. "This is a tacit admission of how fragile the recovery of the world economy is," he says. Harvard's Stein counters that regulators could have gotten results quickly by limiting the amount banks could spend on executive pay and dividends until they raised new capital. That's what the U.S. did after stress-testing its 19 biggest banks and demanding $75 billion of fresh capital injections within six months. The banks managed to meet and even exceed the capital levels in two months, so eager were they to rid themselves of the restrictions on pay and dividends.

Sheila C. Bair, chairman of the U.S. Federal Deposit Insurance Corp., and Daniel Zuberbühler, vice-chairman of Swiss banking regulator Finma, pushed for a phase-in period of five years as well as higher ratios, according to participants in the meetings and others briefed on the discussions. Axel A. Weber, head of Germany's Bundesbank, wanted lower ratios—and 10 years to phase in the rules. Banks owned by Germany's regional governments are saddled with bad U.S. assets and local loans gone sour. They would need further bailouts to meet the new rules quickly. Germany's 10 largest banks (including some of the regional banks) would need more than $100 billion of fresh capital to comply, according to estimates by the Association of German Banks.

"Acceptable Compromise"

U.S. Treasury Secretary Timothy F. Geithner pushed for higher capital ratios, too, according to people close to him. Yet the U.S. had to heed others' concerns about the economy, one committee member says. "It's certainly a compromise, but an acceptable compromise," Bundesbank Vice-President Franz-Christoph Zeitler says.

It wasn't only Germany that won breathing space. Other European banks, such as France's Crédit Agricole (ACA:FP), which might have been forced to raise fresh capital were the rules to go into effect sooner, will "benefit significantly from the delay," Credit Suisse (CS) wrote in a Sept. 13 report. "The transitional times are much longer than anyone had expected," says Cory Gunderson, head of global risk and compliance practices at Protiviti, a consultant to banks.

The committee also narrowed the definition of what constitutes common equity. Jamie Dimon, chief executive of JPMorgan Chase (JPM), said on Sept. 14 that due to the change in definition his bank's current common stock ratio would go from 10 percent to 7 percent. That would be the minimum acceptable level under the new rules. By holding onto some of its profits and by lending a little less and reducing some derivatives positions, JPMorgan aims to increase its common-stock ratio to 9 percent by late 2011, Dimon said.

One new rule, the liquidity coverage ratio—which ensures that a lender has enough cash or easy-to-sell assets to cover a month's worth of liabilities—faced much less opposition from bankers, who know that a lack of liquidity finished off Lehman Brothers and Bear Stearns. Yet the rule's starting point is early 2015 instead of the next year or two. "We were expecting earlier implementation, but to their credit, the regulators decided to take a harder look at it to make sure it doesn't have unforeseen consequences," says Mary Frances Monroe, vice-president for regulatory policy at the American Bankers Assn., the leading bank lobby. The unforeseen consequence could be delay of a rule that might prevent the next crisis.

The bottom line: The Basel committee imposed strict new capital rules to avoid another bank crisis. Yet the banks have a long time to comply.

    Before it's here, it's on the Bloomberg Terminal.