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BrackenNovember 25 2013

Why it is time to kill the Basel illusion

Banks, regulators and consultants are all trying to preserve a Basel capital measurement that relies on a discredited process of risk-weighting assets.
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In July 2013, the US Federal Reserve finalised its rules for the implementation of Basel III capital requirements for US banks. This announcement came about six years after the Fed had approved rules for the implementation of the Basel II framework. Let us note that during this six-year interval, not a single major US commercial bank had adopted Basel II.

Furthermore, the major US bank regulators recently proposed to double the simple leverage rule under Basel III, which requires tangible common equity equal to 3% of total assets, for the largest US banks. The simple leverage rule, as well as the US regulators’ most recent proposal in this regard, reflects the high degree of confusion and ambivalence that exists regarding the Basel framework. And rightly so, as the Basel system has become an albatross around the neck of the banking system and its regulators.

The Basel framework, with its quantitative and model-driven approach, occupied the best minds the financial world had to offer in risk management and quantitative techniques for many years. The framework is based on a granular system that allocated risk weights at the individual asset level based on the risk characteristics of the asset class. At least that was the theory.

The result would be risk-weighted assets, against which Tier 1 and Tier 2 capital were then measured. It gave the illusion of a degree of precision, not just to the regulators, but also to the banks themselves. As such, the Basel regime gave the illusion of safety as the major global banks, including Lehman Brothers, met and even exceeded Tier 1 and Tier 2 risk-weighted capital requirements. But both of these illusions came quickly undone with the serial financial collapses of 2008 and the ensuing financial crisis.

A failing system?

The events of 2008 clearly underscore the fact that Basel has failed as a risk management system and it also failed to prevent or mitigate the 2008 crisis. That is not an accident as the Basel framework was, and continues to be, a major contributor to systemic financial risk and as such played an important role in causing the 2008 crisis. In study after study, including the most recent ones issued by the Basel Committee itself, the system’s flaws have been uncovered.

First, the Basel system violates the principle of risk invariance, with significant variations of the level of risk-weighted assets over time and across institutions. These differences are largely attributable to the arbitrary nature of the underlying statistical models, assumptions and data. It is also worrying that the level of risk-weighted assets as a percentage of total assets has been declining since the onset of the financial crisis. Second, the framework can be easily gamed, leading to concentrations of exposures and asset bubbles. Finally, it cannot take into account the highly interconnected nature of the global banking system.

Basel III is supposed to address the flaws of Basel II, but all it does is add more levels of complexity. Adding increasing regulatory requirements to make the system work will only guarantee that it will make an unworkable system even more unworkable. The fact that Basel III adds a simple leverage rule is in itself an admission of failure. 

Keep it simple

The case against the Basel framework is also a compelling case for replacing it with a simple tangible common equity (TCE) leverage rule. First, to provide a buffer against unexpected losses, capital has to be measured against all assets, not just risk-weighted ones. Second, a TCE rule is blunt, but cannot be gamed. Finally, a TCE rule would create a level playing field for smaller players. 

Yet, the Basel system lives on, like the creature from the black lagoon, propped up by a ‘financial institutions regulatory consultant’ complex, which promotes the vested interests of all the parties involved – financial institutions, regulators and the Basel Committee – to perpetuate the system. It is time to kill the creature.

Karim Pakravan is an associate professor of finance at DePaul University in the US, and a former foreign exchange strategist for JPMorgan.

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