New Reforms Could Make Banks More Vulnerable

Basel reforms are supposed to strengthen financial stability. The wrong reforms won't.

Stability requires the right rules.

Photographer: Tim Boyle/Bloomberg

The review of global banking regulation that began in the aftermath of the financial crisis is nearing completion. The Basel Committee on Banking Supervision has not been able to reach a final agreement despite the urgent need. Nobody disagrees on the goal or the main instrument: to strengthen financial stability through higher and more robust capital requirements. But achieving the objective of stability depends in part on getting the composition of capital requirements right. Unfortunately, current proposals fall short. 

To see why, it’s important to consider that capital requirements come in two forms: minimums and buffers. How requirements are divided between the two can make a world of difference. Proposals currently debated in Basel will, if adopted, shift capital requirements away from buffers and towards higher minimum requirements. That will make banks more vulnerable to crises and reduce banks’ ability to serve customers when it is most needed.

High capital requirements encourage banks to act more prudently. They also foster confidence by increasing the banks’ loss-absorbing capacity. By making insolvency less likely, this protects the banks’ creditors. This is an essential stability feature as creditor uncertainty can trigger self-fulfilling liquidity crises. In this respect, Sweden has led the way by imposing stricter capital requirements for its most important banks than those envisaged in Basel.

However, imposing high total capital requirements isn’t enough. The incentive to limit risk-taking in normal times may be in place, but unless capital requirements come in the right form, creditors may become more nervous and banks less stable if losses do occur. They can also make banks more prone to react to losses by drastically curtailing credit, and, as a result, make the overall economy less resilient to a downturn.

If a bank breaches its minimum requirement, its license is in jeopardy. And loss of the license will trigger liquidation or resolution. The latter means (in the European Union) that the government takes full control of the bank. It can even sell it to new owners. Taking firm measures when a bank is insolvent is necessary and appropriate. But doing it when the bank is solvent (that is, has significant capital left) is more problematic and is likely to have social costs.

That is the risk with the incentives contained in the current proposal. First, a bank whose capital ratio approaches the minimum may reduce lending to improve its capital ratio. Second, faced with the prospect of resolution -- a costly and uncertain process to restructure the bank -- investors and creditors of even solvent banks are likely to withdraw financing. In a broad downturn, where many banks face losses, these forces combine to put a further drag on the economy by limiting access to financing for households and companies.

To avoid creating the wrong incentives for banks, a sound capital regime must ensure that banks have capital levels that are well above the minimum. The best way to achieve this is through buffer requirements. Buffers are by definition shock absorbers: They allow a bank to absorb losses while continuing to function normally. Of course, the bank will have to recapitalize, and it may have to do so by entering into a formal recovery procedure, under close scrutiny from the regulator. To rebuild the buffer, it also has to restrict dividends. But in contrast to minimum requirements, buffers incentivize a bank hit by losses to raise new capital to stay in business and be able to run its affairs without extra constraints again.

Giving a solvent bank a chance to recover in this orderly fashion is sensible also from the point of view of customers and society more broadly. The bank can continue to support its customers with credits. While minimum capital requirements in the event of insolvency benefit creditors and in a broad sense the taxpayers, buffers also protect the functions of banks.

Sizable buffers are a key feature of a sound capital regime. Accordingly, a large share of the high capital requirements in Sweden is made up of buffers. However, proposals currently debated will shift capital requirements away from buffers and towards higher minimum requirements.

For example, the current proposal is to set a minimum leverage ratio -- which roughly corresponds to the relation between capital and total assets -- of 3 percent. For most banks this is less than the total capital required under the risk-weighted rules. But that misses the point: As a minimum requirement, it raises the floor and reduces banks’ effective capital buffers. The leverage ratio would cut the buffers of the large Swedish banks by more than half. Similar effects would occur in other countries with large shares of residential mortgages and other low risk-weight assets, such as Denmark and the Netherlands.

Note that the concern here is not the level of the resulting capital requirements. It’s all about the form. For example, if the leverage ratio is introduced as a buffer requirement rather than as a minimum, a ratio higher than 3 percent would be appropriate. This would also be fully in line with Sweden’s emphasis on high total capital requirements.

High minimum restrictions on risk weights –- in the Basel jargon, known as output floors −- could effectively work in a similar way by raising minimum requirements. And the EU proposal to restrict use of country-specific (so-called Pillar 2) requirements for addressing macro-prudential risks could further reduce national regulators’ scope to create effective buffers.

Other things being equal, with high minimums, resolution becomes a greater threat. This is not desirable. Banks should have ample capital resources which can be used to weather crises and keep them from failing. Using high minimum requirements to trigger early intervention in solvent banks and resolution proceedings is not unlike stopping the car and walking to the gas station when the gas tank is running low, but not empty.

The debate over capital requirements is still open. The Basel Committee has yet to come to a final agreement. And once that agreement is in place, EU legislators must find the right balance between minimums and buffers in the overall capital regime implemented for European banks. Much is at stake in that process.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

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