For Banking Regulations, Simpler Is Better

More than four years after a financial breakdown plunged the world economy into the worst slump since the Great Depression, efforts to build a stronger global system of bank regulation are barely inching forward. Regulators seem overwhelmed by the complexity of their own reforms.

To make faster progress toward a safer system, governments must aim for greater simplicity.

Last week the Federal Reserve and other regulators said U.S. financial institutions won’t be held to a Jan. 1 deadline to boost their capital -- the main defense against losses -- as required by the new Basel III international banking standards.

The U.S. isn’t alone. At the end of October, the Financial Stability Board -- the multinational panel overseeing the Basel III reforms -- said that only six of the 28 global banks it had identified as “systemically important” would be covered by the new rules on the agreed start date.

As Andrew Haldane of the Bank of England recently explained, the problem lies in legislating national rules that conform to the new Basel standards. That’s difficult because the standards are so complicated. The Basel I agreement of 1988 was 30 pages long; Basel II in 2004 logged in at 347 pages; Basel III is 616.

Basel III is a model of brevity compared with the Dodd-Frank Act that codifies the broader U.S. regulatory response to the crisis. Haldane has estimated that the rule-making could ultimately amount to 30,000 pages. Many of those pages are the result of banks’ efforts to insert exceptions and caveats.

The worst effect of the growing complexity -- aside from delay -- may be that the rules, once written, won’t work. Rules that differ in myriad ways from country to country widen the scope for regulatory arbitrage. Beyond that, the financial crisis belies the idea that increasingly complex rules are the right way to control an increasingly complex system. Our unfortunate experience with Basel II demonstrates how well that works.

Simple is best, especially when it comes to the core of the new standards: capital adequacy. A capital ratio, at its essence, should be the amount of money that a bank’s shareholders put at risk as a percentage of the bank’s assets. Basel III complicates the calculation by allowing banks to place a lower weight on supposedly safe assets and by adding other obligations, such as hybrid bonds, to the definition of capital.

Basel III does introduce a simple ratio of equity to assets, but sets the adequacy level at just 3 percent. In other words, a mere 3 percent decline in the value of a bank’s assets -- far less severe than what happened in the recent crisis -- would be enough to render it insolvent. Worse, the ratio is proposed merely as a supplementary monitoring tool, not the binding regulatory limit it should be.

Finance experts have advocated, and Bloomberg View supports, a simple equity-ratio requirement of as much as 20 percent of assets. Research by various economists, including Anat Admati at Stanford University and David Miles at the Bank of England, suggests such sharply higher capital requirements would be a net benefit for the economy. To be sure, regulators will still have to take the nature of assets into account: If a bank specializes in high-risk real-estate lending, for example, even 20 percent might be too little. A balance must be struck, but it’s increasingly clear that regulators have erred too far in the direction of complexity.

Governments’ failure to meet deadlines that were far too lenient to begin with demonstrates the need for a new and simpler approach. If regulators are going to take extra time, they should attend to the underlying cause of the backsliding. They’ll get better rules into the bargain.

To contact the senior editor responsible for Bloomberg View’s editorials: David Shipley at