Basel Endgame: the system’s saviour or liquidity threat?

Those in favour see it as vital to shore up the US banking system. Those against it call it a “nightmare” that could devastate lending to Americans. In blistering opening remarks in the US Senate Committee on Banking, Housing and Urban Affairs, ranking member Senator Tim Scott argued that it could even threaten the “American dream”.

It is the US banking regulatory agencies’ final interpretation of the 2017 Basel III Accords, dubbed ‘Basel Endgame’. It is a set of rule changes that are both extensive (running to some 316 pages in the Federal Register) and highly technical, but at its core lies the requirement for banks to hold capital reserves relative to the riskiness of their business. Funding that comes from shareholders (equity) rather than from depositors or bondholders (borrowing). The bottom line is increased capital. Estimates suggest that, under Basel Endgame, the largest US banks will need an additional $2 of capital for every $100 of risk-weighted assets.

And it is fast approaching judgement day for the final rules. Comments closed on January 16 — next, there will be a vote by US regulators, followed by a three-year phase-in period.

“Somehow bankers have been able to convince politicians that higher capital requirements will lead to fewer dollars to lend to Americans. It is clearly wrong,” said Stephen Cecchetti, the Rosen Family Chair in International Finance at Brandeis International Business School. Mr Cecchetti was making his remarks in a debate held at the Peterson Institute for International Economics in mid-December last year.

Mr Cecchetti, who formerly served as the head of the monetary and economic department of the Bank for International Settlements, believes that, if anything, well-capitalised banks have more skin in the game and are better equipped to increase their capacity to lend, even in leaner times, making the system less procyclical.

He proposed a thought experiment. “Let’s say a bank increases capital by retaining earnings. Is it going to reduce lending because it has more funding from equity sources?” he asked.

What does the data say? Mr Cecchetti produced a graph using data available from the Federal Reserve Board showing a correlation — not necessarily a causation — between an increase in net worth as a fraction of total assets and an increase in lending as a fraction of total assets. “For each percentage point of increase in capital funding, lending seems to go up by two percentage points,” he argued.

None of this is to say that the higher capital requirements of Basel Endgame come without any cost. “Capital funding is expensive. From the banks’ perspective it is expensive, but these are private costs, not social costs,” Mr Cecchetti said.

He is clear: greater capital requirements have private costs to banks, but the charge that there will necessarily be fewer dollars to lend to healthy borrowers is plain wrong.

The risk of ditching Basel Endgame could also spell catastrophe. “For the US not to fully implement Basel III at this point, it would actually be a disaster and could spell the end of the international standard setting that we all benefit from,” he said.

Current distortions incentivise banks to borrow rather then raise equity

The biggest distortions in the tax law and bankruptcy code favour debt finance and increases in leverage and risk-taking by banks, Mr Cecchetti argues. He told The Banker that in most jurisdictions interest payments are treated as a pre-tax business expense, so they reduce taxes. By contrast, dividend payments to equity holders come from after-tax profits. The effect is that taxes increase the incentive for banks to borrow, because higher borrowing increases the return to equity investors.

Mr Cecchetti’s view is the bank’s owners have no incentive to reduce the probability of failure or the loss given failure. Instead, they will want to take on more debt to “gamble for resurrection”, shifting the risk to the debtholders and the public.

He outlines an example. “Let’s take an extreme case, where a bank has experienced sufficient losses to wipe out all the value of its equity. In this case, the ratio of debt to equity is infinite, but the shareholders still have a claim on the bank’s profits. The shareholders would like the bank to continue borrowing and not to issue any new equity. The reason is that without new equity holders all of the profits will go to existing owners. At the same time, any losses will be borne by the debt holders. Or, in the case where funding is from insured deposits, the losses are borne by the deposit insurance fund.”

Will higher capital requirements push banks to retreat from short-term funding?

Yao Zeng, Cynthia and Bennett Golub Endowed Assistant Professor, University of Pennsylvania Wharton School, took a more nuanced view of the rules. Mr Yao cautioned that the higher capital requirements could in fact jeopardise banks’ roles as “market makers” and arbitrageurs of short-term funding, particularly when it comes to US Treasuries, corporate bonds, and most of all repo.

“What happened in the past decade? Banks retreated from providing short-term liquidity partially due to increasing capital requirements,” he said. Instead, filling the gap, we saw non-banks such as hedge funds “kicking in” disrupting treasury markets.

Mr Yao urged authorities to “keep in mind” the banks’ roles as market makers and to see “the whole picture”. He urged the consideration of recent liquidity stress episodes with central banks intervening.

But Mr Cecchetti was unconvinced. “Should we have central banks that are ready to intervene? Yes. Should we have banks that are unsafe because we want them to provide to markets? Absolutely not.”

Mr Cecchetti is pleased that banks retreated from short-term funding. “There are certain things we want to drive out of banks. We want to push them into other areas of the financial system. Most of this stuff — including repo and US Treasury trading — has been driven out of the banks per se and I’m in favour of that,” he said. “These are intended consequences of the changes.”

One of the key criticisms of the rules is that they go over and above the actual standards negotiated by the Basel Committee, in which the US was a key participant. Both Mr Yao and Mr Cecchetti agreed that the US interpretation of the rules were in fact more stringent. “We have to remember that the requirements set by the committee are the lowest common denominator of international agreement,” said Mr Cecchetti.

The importance of mark-to-market accounting

Taking a step back from the capital requirement rules, Mr Cecchetti highlighted three main lessons to take into account: banks will always be bailed out (even mid-sized banks); supervision is essential but never sufficient; and he urged the consideration of the merits of moving to “mark-to-market” accounting, which quantifies the current market value of an institution’s assets and liabilities, rather than the purchase cost.

“We need to revisit accounting rules, a move to mark-to-market accounting and away from book value accounting. This would have a number of benefits: it focuses supervisors’ attention on the frailest institutions and forces authorities to act in a timely manner,” he said.

Silicon Valley Bank would have been caught out much earlier had mark-to-market been in place, he argued. “If the resolution authority had been acting based on something closer to market prices SVB would have been shut down in the middle of 2022, based on the prompt corrective action rules 2% leverage ratio. Its leverage was clearly below the 2% by the middle of 2022 if you even read its quarterly report, but the authorities were required to use different accounting practices for their decisions.”

The lesson of March 2023 is clear to Mr Cecchetti. “The unrealised losses that the Federal Deposit Insurance Corporation computed that were on marketable assets were about $750bn. If you were to do mark-to-market accounting, banks would have had to hold higher capital to begin with — yes, those numbers could be quite big, but interest rates were rising during 2022, eating into the valuations of all of the banks’ assets and they should have been ready with buffers that were appropriate. Then we wouldn’t find ourselves where we are now.”