Basel III: Just one false move and banking gets it

Momentum is gathering for an increasingly tough stance on banks, with many governments positing levies on them, and regulators broadening the debate to include philosophical questions around the social relevance of various bank activities.

Against this backdrop, the Basel Committee has an unenviable task. Under intense pressure from the G-20 governments - all keen to be seen to 'be doing something' about the banks - this club of bank supervisors must come up with a new regulatory framework at speed.

The new proposals for Basel III address one of the key failures of Basel II, which allowed banks' common equity (or 'core' Tier 1), the purest and most flexible type of capital, to shrink to as little as 2% of risk-adjusted assets. They also remedy a whole host of other weaknesses exposed by the financial crisis, including liquidity, leverage, credit risk and the pro-cyclicality of Basel II.

The banking industry is extremely wary of criticising the current proposals for fear of seeming self-serving, but they are right to be worried about some of the provisions and, more specifically, the cumulative effect of the architects' gold-plated approach to individual areas.

The new, tighter definition of capital will exclude such things as tax-deductible assets and include short-term losses on securities. And with more capital also required in absolute terms, many bankers believe that this provision alone could wipe out much of the equity of several European banks. One analyst suggests that it would put all of Germany's Landesbanken out of business.

Provisions to constrain leverage hark back to a 1970s way of looking at banks, discounting all netting and all collateral arrangements, as well as adding in the notional value of sold derivatives. This will drastically balloon bank balance sheets, and could lead banks into extreme measures to cut balance sheets down to size.

In addition, for all the belts and braces of Basel III, it does not protect against the odd basket-case bank getting into trouble in the future, as another bank is sure to do. And no matter how much you increase the safety padding around each bank in the system, if one falls off a cliff, it causes no end of trouble for all of the others.

If it gets the calibrations wrong on only one or two of the key provisions, the Basel Committee runs the risk of undermining the fundamental economics of banking, without actually protecting the system as a whole.