DouglasJ.

Elliott TheBrookingsInstitution July23,2010

BaselIII,theBanks,andtheEconomy
ByNovember,bankingregulatorsarelikelytocompleteaninternationalagreementthatwilldetermine howstrongbanksmustbe.Toughnewrulesoncapitalandliquidityarebeingnegotiatedthroughthe BaselCommitteeonBankingSupervision(BaselCommittee).Theagreement,whichisknownasBasel IIIbecauseitwillbethethirdversionoftheserules,willhavealargeeffectontheworldsfinancial systemsandeconomies.Onthepositiveside,newlytoughenedcapitalandliquidityrequirements shouldmakenationalfinancialsystemsandindeedtheglobalfinancialsystemsafer.Unfortunately, enhancedsafetywillcomeatacost,sinceitisexpensiveforbankstoholdextracapitalandtobemore liquid.Itisbeyondseriousdisputethatloansandotherbankingserviceswillbecomemoreexpensive andhardertoobtain.Therealargumentisaboutthedegree,notthedirection. ThebankingindustryarguesthatBaselIIIwillseriouslyharmtheeconomy.Forexample,theInstituteof InternationalFinance(IIF)calculatedthattheeconomiesoftheUSandEuropewouldbe3%smaller afterfiveyearsthanifBaselIIIwerenotadopted.Myownanalyses,andthoseofotherdisinterested parties,generallysuggestamuchsmallercostthatwouldseemtobeconsiderablyoutweighedbythe safetybenefits.Astherecentcrisisclearlyattests,severefinancialcrisescancausepermanentdamage totheworldseconomy,imposingeconomiclossandemotionalpainonhundredsofmillions,ifnot billions,ofpeople.Itisworthwhiletogiveupalittleeconomicgrowthintheaverageyearinorderto avoidthesemajorimpacts,asmyworksuggestswouldbethecase.Ontheotherhand,iftheindustryis right,theadditionalsafetyisprobablynotworththecostandamoremodestregulatoryrevampwould bepreferable. ThispaperexploresthefollowingquestionsaboutBaselIII. WhatisBaselIIIandwhoismakingthedecisions? WhatisthetimetableforBaselIII? Whatarecapitalandliquidity? Whatarethecurrentrules? Whataretheproposedchangesfromthecurrentrules? Whatstaysthesame? Whatarethemajorareasofdisagreement? Willtheoriginallyproposedchangesortimetablebemodified? WhatarethelikelyeffectsofBaselIII?

WhatisBaselIIIandwhoismakingthedecisions?
BaselIIIisasetofproposedchangestointernationalcapitalandliquidityrequirementsandsomeother relatedareasofbankingsupervision.Itisthesecondmajorrevisiontoanoriginalsetofrules,now knownasBaselI,whichwaspromulgatedbytheBaselCommitteein1988.Thecommitteewas establishedinthemid1970s,afterthefailureofasmallGermanbank(Herstatt)sentshuddersthrough theglobalfinancialsystemasaresultofpoorcoordinationbetweennationalregulators.TheBasel Committeeiscomposedofbankingregulatorsfromanumberofindustrializedcountries,withacore membershipconcentratedinthetraditionalbankingpowerswithinEurope,plustheUSandJapan. TheBaselaccordsarenotformaltreatiesandthemembersofthecommitteedonotalwaysfully implementtherulesinnationallawandregulation.OneprominentexampleofthisisintheUnited States.WehadnotimplementedtheBaselIIrevisionsforourcommercialbanksbythetimeofthe financialcrisis,whichputanysuchchangesonhold.Itisnotclearwhetherwewouldeventuallyhave implementedthem,despitehavingbeencloselyinvolvedinthenegotiationsthatledtothatagreement. Intruth,fewcountrieschoosetoimplementeverydetailoftheBaselaccordsandtheysometimesfind unexpectedwaystointerprettheaspectstheydoimplement.Despitethis,theaccordshaveledtomuch greateruniformityofcapitalrequirementsaroundtheglobethanexistedpriortoBaselI.Infact,the uniformityextendswellbeyondthecountriesrepresentedontheBaselCommittee,asmostnations withsignificantbankingsectorshavemodeledtheircapitalregulationontheBaselrules. TheBaselCommitteeislooselyaffiliatedwiththeBankforInternationalSettlements(BIS)whichisoften referredtoastheclubfortheworldscentralbankers.TheBISprovidescertainfinancialservicesto centralbanksandalsoservesasavehicletopromotecooperationbetweenthem.Inaddition,it providessupportservicestotheBaselCommitteeandseveralothermultilateralbodiesfocusedonthe worldsfinancialsystems.ProminentamongtheseistheFinancialStabilityBoard(FSB)whichwas chargedlastyearbytheheadsofgovernmentoftheGroupofTwenty(G20)nationswiththemissionof promotingfinancialstabilityaroundtheworld.Inthatcapacity,ithasbeenaprominentadvisortothe BaselCommitteeinitsworkonBaselIII.

WhatisthetimetableforBaselIII?
TheG20headsofgovernmenthavechargedtheBaselCommitteewithfinalizingtheBaselIIIrulesin timefortheG20meetinginSeoul,KoreaonNovember1112,2010.Theprocessleadingtothatstarted withtheissuanceofconsultationpapersinDecemberof2009thatoutlinedthechangesproposedby theBaselCommitteeforthecapitalandliquidityrequirements 1 .CommentsweresolicitedbymidApril of2010andmanypartiesrespondedatlength.Inparallel,theBaselCommittee,withassistancefrom theBISandtheFSB,hasbeenconductingaQuantitativeImpactStudy(QIS)toestimatethepotential effectsonthefinancialmarketsandtheeconomyofputtinginplacetheproposedchanges.Itappears thattheQIShasbeencompletedindraftformandisbeingreviewedbytheBaselCommitteeandthe
1

Thetwopaperscanbefoundat:http://www.bis.org/publ/bcbs164.htmand http://www.bis.org/publ/bcbs165.htm

memberregulators.ReleasetothepublicisexpectedinSeptember,althoughthereisnoannounced deadlineforthis.TheQISwillpresumablyinfluencetheBaselCommitteeschoicesonthelevelsof certainkeyratiosandonanyrevisionsthatitdeemsnecessarytotheelementsoftheoriginalproposal. TheintentionistoimplementBaselIIIbytheendof2012,althoughitseemsclearthattherewillbe transitionperiods,observationperiods,orphaseinsforanumberofthemoreimportantrequirements, aswellasgrandfatheringofcertainfeaturesofexistingregulation.Alloftheseexceptionswouldbe intendedtoeasethetransitionalimpactofBaselIII,whichcouldpotentiallybequitelargebythetimeit isentirelyphasedin.

Whatarecapitalandliquidity?
Capitalisoneofthemostimportantconceptsinbanking.Unfortunately,itcanbedifficultforthose outsidethefinancialfieldtograsp,sincethereisnocloseanalogytocapitalinordinarylife.Inits simplestform,capitalrepresentstheportionofabanksassetswhichhavenoassociatedcontractual commitmentforrepayment.Itis,therefore,availableasacushionincasethevalueofthebanksassets declinesoritsliabilitiesrise.Forexample,ifabankhas$100ofloansoutstanding,fundedby$92of depositsand$8ofcommonstockinvestedbythebanksowners,thenthiscapitalof$8isavailableto protectthedepositorsagainstlosses.If$7worthoftheloanswerenotrepaid,therewouldstillbemore thanenoughmoneytopaybackthedepositors.Theshareholderswouldsufferanearlycompleteloss, butthisisaconsideredaprivatematter,whereastherearestrongpublicpolicyreasonstoprotect depositors. Ifbankbalancesheetswerealwaysaccurateandbanksalwaysmadeprofits,therewouldbenoneedfor capital.Unfortunately,wedonotliveinthatutopia,soacushionofcapitalisnecessary.Banksattempt toholdtheminimumlevelofcapitalthatsuppliesadequateprotection,sincecapitalisexpensive,butall partiesrecognizetheneedforsuchacushionevenwhentheydebatetherightamountorform. Thesubjectofcapital,andregulatorycapitalrequirements,isacomplexoneandwillonlybe summarizedhere.AmorecompletediscussioncanbefoundinBankCapital:APrimer 2 .Asexplained inthatpaper,commonstockisnottheonlytypeofsecuritythatisconsideredtobecapitalbecauseof theprotectionitprovidesdepositorsandotherpartiesthatregulatorscareabout.Certainformsof preferredstock,andtoalimitedextentdebt,canalsoserveascapital. Itisworthnotingthatbankregulationgenerallyusesthereportedaccountingnumbersasthebasisfor calculatingcapitallevels,withoutadjustingformarketvaluationsexcepttotheextenttheyarecaptured bystandardaccountingrules,suchasoccurswithcertainmarktomarketrequirements.Inparticular, themarketcapitalizationofbankstocksintheheartofthecrisistendedtobesubstantiallylowerthan theaccountingvalueoftheequityofthesebanks.Essentially,themarketbelievedthataccounting
2

Pleasesee http://www.brookings.edu/~/media/Files/rc/papers/2010/0129_capital_elliott/0129_capital_primer_elliott.pdf

valueswereoverstatedorthatsubstantialnewlosseswouldoccurinthefutureorthemarketwastoo lowfortechnicalreasonsunrelatedtoexpectationsoffutureperformance.Noneofthesefactorswould directlyaffectregulatorycapitallevels,althoughregulatorsarealwayswisetonotethesedivergencesin casetheyindicatethatthemarkethasdeterminedthatthebanksareinworseshapethanappearson thesurface. Liquidityreferstotheabilitytosellanasset,orotherwiseconvertittocash,withoutincurringan excessivelossindoingso.Liquidityalmostalwaysincreasesthelongerthetimeframebeingconsidered. Ahouse,forexample,maybeaveryilliquidassetifoneneedstosellitwithinaweek,butmaybequite liquidifoneisgivenfiveyearstomanagethesale.Morebroadly,theliquidityofabankoftenrefersto thematchingofitsobligationswithitsfundingsources.Abankwithhighlyliquidassetswouldgenerally beconsideredfairlyliquidevenifitsfundingsourceswereofquiteshortmaturities,sincetheassets couldbeliquidatedasneededtocoveranylossoffunding.Abankwithlessliquidassetsmightbefineif itsfundingsourceswerelockedinforlongperiods,butcouldbeinserioustroubleinapanicifitrelied onshorttermdebtordepositsthatmightflowaway.

Whatarethecurrentrules?
ThecoreoftheBaselrulesoncapitalreflectsabeliefthatthenecessarylevelofcapitaldepends primarilyontheriskinessofabanksassets.Sincecapitalexiststoprotectagainstrisk,itstandsto reasonthatmoreisneededwhengreaterrisksarebeingtaken.Thefocusisontheassetsidebecause liabilitiesaregenerallyknownwithgreatprecision,sinceadepositorabondmustberepaidbasedon specificcontractualterms.(Thisisamajorcontrastwiththeinsuranceindustry,wherethefuturecosts ofpromisestoprotectagainstvariousevents,suchasfires,areunknown.)Unlikebankliabilities,bank assetscangodown,oroccasionallyup,invalue.Inparticular,bankloansmaynotberepaidand securitiesmaydefaultormayneedtobesoldatatimewhentheirmarketvaluehasdeclined. Theoriginal,BaselI,rulesgroupedallassetsintoasmallnumberofcategoriesandappliedarisk weightingtoeachcategory.Thetotalvalueofeachassetismultipliedbyitsriskweightingandthis adjustedamountisaddedacrossallassetstoproduceatotalriskweightedasset(RWA)figure.The percentageweightingforeachcategoryrangesfrom0%,forextremelysafeinvestmentssuchascash andUSgovernmentsecurities,to100%forriskierclassesofassets.(Inafewcases,theweightingsnow exceed100%forcertainveryriskyassets,suchasloansindefaultorimminentdangerofdefaultandthe riskiesttranchesofsecuritizations.)Forexample,residentialmortgageloansoftenhavea50%risk weighting,sothata$1millionmortgagewouldgenerateariskweightedassetof$500,000.Ifabank weretryingtoholdcapitalequalto10%ofitsRWA,thenitwouldneed$50,000ofcapitaltocoverthis mortgage. TheBaselIIrevisionsmadefourmajorchangestotheriskweightedassetcalculations: Refinementofcategories.BaselIIbrokethecategoriesdowninmuchgreaterdetailthaninBaselI,with morevariationintheriskweighting,sinceitwasrealizedthatthecrudenessoftheoriginalsimple categorieswasencouragingagreatdealofgamingandmisallocationofresources.Inadditiontothe

weaknessesinherentinusingasmallnumberofcategories,theweightingshadbeenfairlyarbitraryand influencedbypoliticalconsiderations.Forexample,Germanyparticularlywantedmortgagestocarrya lowerriskweightingthanotherbankloans. Ratings.Ratingsfromthemajorcreditratingagenciesbecameasignificantfactorintheriskweightings, whichhadnotbeentruewhenonlybroadcategorieswereused. Internalriskmodeling.Itwasagreedthatthesophisticatedglobalbankscouldusetheirowninternal riskratingmodelstodeterminetheriskweightingsfortheirownparticularassets,withsome exceptions.Theideawastoalignregulatoryriskcalculationswiththeconsiderablymoresophisticated riskmodelsthatwerebeingusedbymajorbanksintheirowndecisionmaking.Thisconceptcountson theselfinterestofthebankstoleadthemtousethebestpossibleestimatesofriskintheirown managementofassets. Tradingassets.BaselIIpromulgatedadifferentmethodforcalculatingtheriskofassetsthatwereheld intradingaccounts,basedontheassumptionthattheriskleveloftradingassetswasprincipally determinedbyhowfartheassetscouldrealisticallyfallinvaluebeforeabankcoulddisposeofthe investments.Thusavalueatrisk(VAR)approachwasused,utilizingstatisticaltechniquestoestimate fromhistoricaldatahowlargealossmightbetakeninunusuallyunfavorablecircumstances. CapitaladequacyundertheBaselRulesisdeterminedbycalculatingaratioofthelevelofcapitaltothe totalriskweightedassets.BaselIdefinedtwotiersofcapital,adistinctionthathasbeenretained.Tier 1,thestrongest,consistsmainlyofcommonstockandthoseformsofpreferredstockthataremostlike common.Tier2addsincertaintypesofpreferredstockthatarelesslikecommonstockandmorelike debt,aswellascertainsubordinateddebtsecurities.Inaddition,Tier2includessomeaccounting reservesthatprovideaprotectivefunctionsimilartootherformsofcapital 3 .Thetwotiersareintended toensurethatthereisenoughtotalcapitalavailabletohandleevenextremeoccurrencesandthatthe bulkofthiscapitalisthestrongerTier1variety.Generally,bankshaveplentyofTier2capital,sothe practicalfocushasbeenonensuringthereisenoughofthestronger,Tier1,formofcapital. TheBaselcalculationsincludeanumberofdeductionsfromthestatedbalancesheetfiguresforcapital. First,andprobablymostimportantly,theBaselagreementsrequirethedeductionofgoodwill,(which ariseswhenacompanyorassetispurchasedformorethanitsbookvalue),effectivelytreatingitas worthlessforthesepurposes.Second,individualnationalregulatorshavechosentofullyexcludeorto
3

Tier2capitalincludesfivebroadcategories.First,somecountries,butnottheU.S.,allowundisclosedreserves thatareeffectivelythesameasretainedearnings,butareseparatelyaccountedfor.Second,somecountriesallow certainassetstobeheldathistoricalvaluesthatcanbewellbelowcurrentmarketvalues.Someorallofthe differencebetweencurrentandmarketvalueswouldbeheldasarevaluationreserve.Third,generalloanloss provisionsmaybeheldwhicharenotallocatedtospecificclaimsandarethereforeavailabletoabsorbany unexpectedlosses.Fourth,certainhybriddebtcapitalinstrumentsareconsideredtohaveenoughoftheaspects ofcommonstocktobeconsideredTier2capital.Fifth,subordinateddebtinstrumentswithatleastafiveyear maturityareallowedtocountasTier2capitaltoalimitedextent.

limittheamountofcertainotheraccountingassets.Forexample,U.S.regulatorslimittheportionof deferredtaxassetsthatmaybecountedinequity,sincethevalueofthoseassetswouldonlyberealized ifabankmakesfuturetaxableprofits,whichmaynotoccurifitrunsintothekindoftroublethatmakes capitalimportant.

Whataretheproposedchanges?
ThefinancialcrisisexposedorunderlinedanumberofareasofweaknessintheBaselIIrules.These problemsledtomanyproposedchangesunderBaselIII,includingthefollowing. Highercapitalratios.Theconsultativedocumentdidnotspecifyfigures,butmadeclearthatthe minimumacceptableTier1andTier2riskweightedcapitalratioswouldberaised.Thiswillhavemajor effects,butisdifficulttodiscussfurtheruntiltheproposedlevelsareknown.Speculationcentersonan increaseofacoupleofpointsintheminimumratios,butthisisnotclear. Useofaleverageratioasasafetynet.Mostbroadly,thecrisispointedouttheproblemswithusingrisk weightedassetcalculationsthatareintrinsicallybasedeitherdirectlyonhistoricalexperience,inthe caseoftheinternalratingsusedbythelargebanks,orindirectly,inthecaseoftheriskweightingsthat aresetbytheBaselCommittee.Thevalueofmanyassetsfellconsiderablymoresharplyandquickly thanwassuggestedbyhistoricalexperience,insomecasesbecausegoodqualitydatadidnotexistfor verymanyyearsandthereforehadonlyreflectedthefavorablemarketconditionsofrecenttimes.In response,thereisbroadagreementthatastraightleverageratioshouldbegivenmoreregulatory weight.Inthiscontext,aleverageratioissimplytheratioofcapitaltototalassetswithnoriskweighting oftheassets.ThishasthemajordisadvantagethatasmuchcapitalwouldhavetobeheldtobackaU.S. governmentbondastobackariskyloan,butitdoesavoidtheproblemscausedbyinappropriatelylow riskweightings.TheBaselIIIrulesthereforeproposetoincludealeverageratioasanadditionaltestof capitaladequacytoserveasasafetynettoprotectagainstproblemswithriskweightings. Tougherriskweightingsfortradingassets.Asecondmajorproblemwasthattheriskweightingsfor tradingassetswereclearlysettoolow,againreflectinganexcessiverelianceonfavorablerecenthistory. Thishasalreadybeendealtwithinamajorsetofchangesthattookeffectinwhatmightbeconsidered BaselIIa,throughasubstantialtougheninginthemethodologyfordeterminingriskweightingsof tradingassets.Itappearsthatcapitalrequirementsintheseareashaveroughlydoubled,onaverage, comparedtotheoldmethodology.TheseruleschangesareretainedunderBaselIII. Eliminationofsofterformsofcapital.Thefinancialcrisisdemonstratedthatsomesecuritiesthatwere consideredcapitalinstrumentswereunusableasapracticalmatterinaseverefinancialcrisis.Capitalis onlyusefulifitcanbemadetoabsorblossesinordertoprotectotherparties,butregulatorswere effectivelyblockedfromforcingthatlossabsorptioninthecaseofsubordinateddebt,whichhad countedincertaincasesasTierIIcapital.Sincethesewerelegallydebtinstruments,theholderscould forceabankruptcyorinsolvencyproceedingiftheyweretosufferaloss.Puttingamajorfinancial institutionintoinsolvencywasviewedasaveryriskymovebypolicymakers,especiallyafterthe insolvencyofLehmanBrotherscausedseveremarketturmoil.Asaresult,subordinateddebtwillno

longercountascapitalevenforTierIIpurposesandothersoftformsofcapitalarebeingeliminatedor subjectedtotighterconditions. Exclusionofsomebalancesheetitemsfromcapital.Followingasimilarlogic,theBaselCommittee decidedthatcertainbalancesheetitemsshouldbeexcludedfromcapitalbecausetheymightnottruly beavailabletoabsorblossesinacrisis.Forexample,abankorbankholdingcompanysownershipstake inaninsurancecompanywouldnolongercountascapital,onthetheorythatitrepresentedcapitalat theleveloftheinsurerandshouldnotberequiredtododoubleduty.Putanotherway,aninsurercould easilybehitbythesamefinancialcrisisasthebankanditsownlossofcapitalwouldcauseproblems bothattheinsurerandthenatthebankwhichwascountingonthevalueofitsinvestment.Minority interests,whichrepresentpartialownershipofapartofthebankinggroupbyoutsideparties,would alsoceasetocount.Yetanothercategoryisdeferredtaxassetswhichrepresentthevalueofprevious losseswhichcanbeusedtooffsettaxesonfutureprofits.Sincethevalueoftheseassetsisdependent onfutureprofits,BaselIIImovestoeffectivelyexcludethem.(Theywerealreadylimitedinsome countries,suchastheUS,whereonlytaxbenefitsforeseentobeusedoverthenextyearwereallowed.) Highercapitalrequirementsforcounterpartycreditrisks.Thecrisisalsoshowedhowmuch counterpartycreditriskexisted,causingthecommitteetotightentherulesforwhencapitalmustbeset asideandhowmuchmustbeearmarkedfortheserisks.Thisincludesmakingadistinctiononthe amountofcapitalneededtobackexchangetradedderivatives,whichcarrylowcounterpartyrisk,and overthecounterderivatives,whichwillnowrequiremorecapital. Newliquidityrequirements.TheBaselCommitteehadlargelyignoredliquidityinthepast,leavingitas oneofthemanyitemsonwhichnationalregulatorshaddiscretiontoregulateastheypleased.Some countries,suchasFrance,hadexplicitliquidityrequirements,butmostvieweditonlyasasubjective itemtokeepaneyeon.However,thefinancialcrisishighlightedthefundamentalfactthatfinancial institutionsdependfortheirsurvivalonmanagingliquidityinordertopreventafatalrunonthebankif confidenceintheirfinancialstrengthevaporated.Asaresult,BaselIIIproposedtwotoughnewliquidity teststhatwouldbestandardizedglobally. First,minimumliquiditylevelswouldbebasedonatypeofstresstestusingstandardizedcalculations. Effectively,thetestmimickedafreezingofthefinancialmarketsforaperiodof[x]monthsduringwhich itbecameextremelydifficulttoraisenewfundsandexistingliabilities,suchasshorttermdebt,would generallyrolloffatmaturity.Coredepositswereassumedtobedrawndowntosomeextent,butmostly toremainatthebank.Noncoredeposits,suchascertificatesofdeposit,wereassumedtorolloff completelyassoonastheycouldbewithdrawn.Maturingdebtwasassumedtorolloffandnotbe replaced.Liquidassetscouldbeusedtocovercashneeds,buthaircutsofvarioussizeswereappliedto reflectthefiresaleinthefinancialmarketscausedbytheadverseconditions. Second,anetstablefundingratiotestwascreated.Thismeasuredthelevelofliquidassetstothe levelofliabilitiesthatmaturedinayearorless.Theintentionwastoforcebankstomovemoreoftheir borrowingtomultiyearfundingsourcesortoinvestmoreheavilyinfairlyliquidassets.

Contingentcapital.BaselIIIendorsedthegeneralideaofaddingcontingentformsofcapital,but proposedfurtherstudyratherthanimmediateimplementation,giventhenumeroustechnicalissuesto beresolved.Contingentformsofcapitalarebasicallydebtsecuritieswhichwouldconverttoequity underpreagreedtermsintheeventthatabankranintoproblems.Itcanbethoughtofasapre arrangeddebttoequityswapandservesthesamepurposeofreducingdebttoequityratiosand allowingatroubledinstitutiontorecapitalizeoutsideofaninsolvencyproceeding. Countercyclicalcapitalrequirements.BaselIIIalsoendorsedtheideathatcapitalrequirementsshould behigheringoodtimesandsomewhatlowerinbadtimes.Thiswouldachievethepurposeofleaning againstthewindandslowingbankingactivitywhenitoverheatsandencouraginglendingwhentimes aretough.Itisunclearatthispointhowthismightbeimplementedandthedegreeofdiscretionthat nationalregulatorswouldhave.

Whatstaysthesame?
Regulators,withtheconcurrenceofworldleaders,havechosentokeeptheessentialstructureofthe BaselIIapproachintactwhiletryingtoimprovethemechanismsoftheaccord.Thisisnottominimize theextentofthechangesdescribedabove,whicharequitesignificant,butrathertoemphasizethat theyareconsistentwiththeoverallframeworkofBaselII.Thetwopossibleexceptionstothisgeneral statementaretheleverageratio,whichdoesnottaketheriskbasedapproachthatisattheheartof BaselII,andtheadditionofaliquiditytest.Inpractice,theleverageratioislikelytobesetatlevelsthat leavetheriskbasedratiosasthekeydeterminantsofthecapitalrequirements,mutingtheeffectadding aleverageratio.Foritspart,theliquiditytestisnottrulyinconsistentwiththecapitaltests,butshould probablybeviewedasasupplementthatisinthespiritoftheoriginalBaselaccords. Oneaspectthatremainsthesamehascomeunderagreatdealofcriticismfromsomeacademicsand marketobservers.BaselIIandIIIbothallowthesophisticatedglobalbankstouseinternalriskmodelsas keydeterminantsoftheircapitalrequirements.Theargumentinfavorofthisisthatbanksdevotefar moreresourcesthanregulatorscantodevelopingsophisticatedapproachestoevaluatingtheriskthey aretakingonandtheyhaveastrongincentivetogetitright,inordertomaximizetheirownprofitability overtime.Unfortunately,wenowknowthattheriskmodelingleadingintothecrisiswasseriously flawedbyacombinationofexcessiverelianceonalimitedhistoricalrecordandperversecompensation incentives.Thereisgoodreasontobelievethatthemodelingisbetternow,bothbecauseofextensive effortstofixtheproblemsandbecausethehistoricalrecordnowincludesamuchworsesetofevents, automaticallyincreasingtheirconservatism.However,manyremainskepticalthatthebasicflawshave beenfixed. Arelatedissueisthatcapitalrequirementsfortradingassetsarestillcalculatedwithextensivereference toValueatRiskcalculations.BaselIIIaddslayersofconservatismthatappeartoroughlydoublethe capitalrequirementsonaverage.However,theVARconceptappearstoworkbetterforevaluatingdaily orweeklyrisksthanforsomewhatlongerholdingperiods.Forthisreason,someobserversareskeptical thattheVARapproachworkseffectivelywhenappliedtolessliquidassets.

Inbothcases,theBaselCommitteehaschosentoretaintheroleofstandardriskmodels,despitean awarenessoftheirflaws.Theconsensusofthecommitteeisthatthebenefitsoutweighthe disadvantagesandthatthereisnoclearlysuperiorapproachesavailable.

Whatarethemajorareasofdisagreement?
ThereisbroadagreementwithintheBaselCommittee,attheG20,andeveninthefinancialmarkets, thatcapitalrequirementsneedtoberaisedinlightofthefinancialcrisis.However,thereare disagreements,particularlybetweenthebankingindustryandthecommittee,onthespecific approachesbeingtakentoachievethispurpose.Aswillbediscussedfurtherbelow,theindustryargues thatthecommitteeisgoingoverboardinmanyareasanddoingsoinwaysthatwillsignificantly,and unnecessarily,raisethecostofprovidingloansandotherbankingservices.Someofthekeyareasof discordare: Netstablefundingratio.ThereseemstobeareasonabledegreeofacceptancethatBaselrulesneedto coverliquidity,buttheindustryhaspushedbackveryhardonthenetstablefundingratiotest.They believethatitwouldforceverysubstantialandexpensivechangestohowtheyfundthemselvesand investtheirassetsandthatthegaininsafetywouldbemarginal.Theyhavemoresupportfrom disinterestedobserversonthisthantheydoontheircomplaintsaboutthehighercapitalrequirements, althoughopinionisdividedintheacademiccommunity.Whateverthemerits,itappearsthatthe industryhassucceededingivingtheregulatorsgreatpauseonthistopicandthetestmaybedropped fromtheinitialBaselIIIrulesandstudiedfurther.Theliquiditystresstesthasgeneratedlessopposition, althoughitiscertainlynotwithoutcontroversyeither.Asaresult,itmightbeincludedinBaselIIIor mightbeputoffalongwiththeotherliquiditytest. Highercapitalratios.Thisfightwillspringupinfullfuryoncespecificcapitalratiosarespecified,butthe bankingindustryhasalreadymadeclearthattheybelieveonlymoderatechangesarenecessary, especiallygivenalloftheotherwaysinwhichcapitallevelsarebeingincreasedintheBaselIIIproposals. Useofaleverageratio.Thereisaheateddebateonthistopic.Virtuallyallregulatorsagreethata simpleleverageratioisausefulwayofcheckingtoseeiftheriskbasedapproachisleadingto excessivelylargebalancesheets.Somecountries,notablytheUS,believethatthisissuchausefulratio thatitoughttobemandatoryandbinding,sothatabanksminimumrequiredcapitalwouldbethe greateroftheriskbasedfigureandtheonederivedfromtheleverageratio.Others,notablyFrance, believeitissimplyoneusefulsupplementalmeasureandthathowitisusedshouldbeuptonational discretion.Theyfurtherpointoutvarioustechnicalproblemsthatcouldmakeitverydifficulttoachieve uniformity,suchasthedifferencesbetweenUSandinternationalaccountingstandards.Someanalyses havesuggestedthatthetwodifferentaccountingregimescouldshowtotalassetsonthebalancesheet thatdifferedbyasmuchas100%,sothatafixedleverageratiocouldrequiretwiceasmuchcapitalin onecountryasanother.Ataminimum,therewillhavetobeanapproachthatadjuststheleverageratio forsuchdifferences.

Thisratiowillprobablyremaincontroversialforalongtime,iffornootherreasonthanthefactthatUS bankshavebeenoperatingunderaleverageratioforsometimeandarealreadyconfiguredtodealwith it,whileEuropeanbankshavenot.Inanutshell,manyEuropeanbankshavelargerbalancesheetsthan USbanks,butfocusmoreonlowerriskassets,sincethisiswhattheBaselruleseffectivelyencourage. AddingaleverageratiowouldforcethemtooperatemorelikeUSbanksintheirassetallocations. ThemostlikelyresultisthattheBaselCommitteewillchoosetoelevatetheimportanceoftheleverage ratio,butdosoinamannerthatallowsthedevelopmentofgreaterconsensusovertime.Forexample, therehasbeentalkofanobservationperiodofseveralyearsbeforeitbecomesbinding,which,in practice,wouldallowforittoremainnonbindingifatrueconsensuscannotbebuilt.Anotherpossibility isforittobebinding,butsetatalowenoughlevelthatitwouldrarelybethedeterminantofthe minimumcapitalrequirements,sincetheriskbasedapproachwouldalmostalwaysyieldahigher requirement. Eliminationofsofterformsofcapital.Everyoneagreesthatcommonstockprovidesthestrongestform ofcapitalprotection.Theproblemisthatcommonstockisalsobyfarthemostexpensiveformofcapital forabanktoraise.Therefore,bankshaveavailedthemselvesofsubstantialamountsofsofter,and cheaper,formsofcapital.Therefore,theindustryhasbeenfightingbackagainsttheeliminationof someoftheseformsandhasalsobeenpushingfortransitionperiodsinwhichsomeorallofthese formsofcapitalwouldcontinuetocountascapital.TheEuropeanandJapanesebanksfeelparticularly stronglyaboutthis,astheyhavereliedsomewhatmoreontheseformsthanhavetheAmericanbanks. Exclusionofsomebalancesheetitemsfromcapital.Banksineverycountrygainconsiderablebenefit fromatleastoneofthebalancesheetitemsthatwillnolongercountascapitalandthereforeputforth argumentsastowhytheyshouldcontinuetocount.TheEuropeansareparticularlyconcerned,because manyoftheircorporatestructuresincludeinvestmentsininsurersandminorityinterestsintheirbanks toamuchgreaterextentthanistrueintheUS.Ontheotherhand,theUSbanksareconcernedabout deferredtaxassetsandaboutmortgageservicingrights,whichareoflesserconcerntotheEuropeans. Therearelegitimateargumentsinalmostallcases,whichiswhytheseitemshadbeencountedas capitalinthepast,butthecommitteestronglywantstoensurethatcommonstock,andnotsofterforms ofcapital,reallydoesconstitutethecoreofcapital.Thisdifficultbalancingactwillberesolvedbyclassic horsetradingamongthedifferentcountriesonthecommittee,balancedbyadesiretomaintainthe overallintegrityoftheBaselIIIproposals. VirtuallyeverypartoftheBaselIIIproposalshasbeenobjectedtobysomeone,sotheaboveshouldnot beviewedasacompletelist,butmerelythemostimportantandcontroversialitems.

Willtheoriginallyproposedchangesortimetablebemodified?
Despitethevariouscontroversies,itappearsunlikelythatthecoreBaselIIIproposalswillbedropped, withtheexceptionoftheliquidityprovisions.Nordoesitappearlikelythatthetimetableforinitial implementationwillbealteredsignificantly.TheG20headsofgovernmentshowastrongdesireto finishthisattheirSeoulmeetinginNovemberanditappearsthatthereissufficientconsensusto

achievethis.Itispossible,ofcourse,thatsomedisagreementswilleffectivelybedeclaredtobe implementationdetailsthatcanbedelayedmodestly,evenifanobjectiveobservermightconsiderthem tobemorefundamentalconceptsratherthanjustdetails.Thatsaid,itwouldbeasurpriseiftherewere amajordelayinacorepartoftheBaselIIIproposals,withtheexceptionoftheliquidityrequirements. Theonethingthatmightcreateapostponementwouldbetheonsetofanewrecessionorsevere financialcrisis,suchastheEurocrisiswasthreateningtobecome.Leadersarenotgoingtowanttorisk slowingtheireconomiesfurtherunderthosecircumstances. Asnotedearlier,itishighlylikelythattherewillbeanumberofarrangementstoeasethetransition oncetheinitialimplementationdateisreached,suchasphasingoutvariousformsofsoftcapitalovera periodofyearsandperhapsphasinginthenewhigherTier1capitalratios.

WhatarethelikelyeffectsofBaselIII?
ThereisveryconsiderabledisagreementabouttheeffectsofBaselIII.Virtuallyeveryoneacceptsthat banksandthefinancialsystemwouldbesaferasaresultofthesechanges,butthatthiswouldcomeat thecostofslowereconomicgrowthinmostyearsduetohighercreditcostsandreducedavailability. However,themagnitudeoftheseeffectsisatissueandverymuchaffectsonesviewofthetradeoff.As notedearlier,theIIF,anindustrygroup,calculatedthattheeconomiesofthemajoreconomieswould beabout3%smallerasaresultofBaselIIIthantheyotherwisewouldbefiveyearson 4 .Thisisavery largeimpactandtheG20leaderswouldprobablyrejectBaselIIIiftheybelievedthesefigures.Noris theIIFsanalysiseventhemostpessimistic.Forexample,theFrenchbankingassociationoffered calculationsthatsuggesteda6%hittotheFrencheconomy. Ontheotherhand,variousdisinterestedobservershaveconcludedthattheeffectswouldbemuch smaller.Myowncalculations,forexample,suggestedthatalargeincreaseincapitalrequirementsinthe USmightonlyincreaseaverageloanpricingabout0.2percentagepoints,withlittleeffecton availability 5 .(Ididnotanalyzetheeffectsoftheliquidityrules,whichcouldbelarger,andIassumeda longenoughtransitioneffecttoavoidabruptchanges.)Anincreaseinloanpricingofthismagnitude wouldlikelyhavequiteminimaleffectsoneconomicgrowth.(Considerhowsmallaneffectthereison theeconomyofa0.25%ratemovebytheFed,whichisthesmallestchangetheynormallymake.) MydiscussionswithEuropeanandUSpolicymakersandregulatorsstronglysuggestthatthekey decisionmakersareheavilydiscountingtheindustrysanalyses,insteadbuyingintotheBasel Committeesownapparentviewthatthedragontheeconomywouldberelativelysmallandmorethan offsetbythebenefitsofgreatersystemicsafety.Thisthinkingmayeitherbeconfirmedoralteredonthe basisofthecommitteesQuantitativeImpactStudywhichshouldbepubliclyavailableinSeptember.
Pleaseseewww.iif.comforthefullinterimreport. Pleaseseehttp://www.brookings.edu/papers/2009/0924_capital_elliott.aspxand http://www.brookings.edu/~/media/Files/rc/papers/2010/0129_capital_elliott/0129_capital_requirements_elliott .pdf
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IftheBaselCommitteeisright,theloweredgrowthrateduringnoncrisisyearsmaybemorethanoffset bytheavoidanceoftrulysevererecessionsbroughtoneveryfewdecadesbywidespread,severe financialcrises.Arecessionasroughastheonewerecentlywentthroughcausespermanentlossesto theeconomyinadditiontotheawfultransitoryeffects.Thelongtermunemployedmayfindtheyare neverabletoreturntoworkandsomeplantandequipmentisjunkedordeterioratesafterbeingoutof serviceforlongperiods.Therearealsoverylonglastingeffectsofthesharpincreaseinnationaldebt thattendstoaccompanysuchsevererecessions.Itisdifficulttopindownthepermanentshrinkagein theeconomy,butmostobserverswouldagreethatitisquitesignificant.Inaddition,ofcourse,the temporaryshrinkageoftheeconomyaddsuptoaconsiderablelossbeforetheeconomyrecoversto morenormallevels.

Conclusion
BaselIIIwillhappen,roughlyonschedule,andwillmakeamajordifferencetotheoperationofthe financialsystem.Bankingwillbesafer,butmoreexpensive,withextensiveramificationsthroughoutthe economy.Despitethedrynatureofdiscussionsoffinancialregulation,theBaselIIIprocessbears watchingclosely.