Will Basel III prevent the next financial crisis? (updated with comments from Johnson and Stiglitz)

[ProSense]

Will Basel III prevent the next financial crisis?

There it is. Basel III, in all its glory. The chart you're looking at is a summary of what international regulators are going to do to try and stop another financial crisis from happening. The numbers atop this post are more important than anything in the financial regulation bill.

The first column is the most important. To simplify it a little, it's the amount of cash (or, to be more precise, common equity) banks have to hold, and it's measured as a percentage of total assets. This is the money that they'll have laying around in case their investments go bad and they need to start paying lenders back. This is the money, in other words, that will stand between the banks and insolvency. (Want a longer explanation? Head here.)

Before the crisis, it was 2 percent. That turned out to be a terrible, terrible mistake. Want to know which banks survived the financial crisis? It was the banks with the most common equity, like JP Morgan. So the regulators at Basel are jacking it up: Now it begins at 4.5 percent. Then there's something called a "conservation buffer," which adds another 2.5 percent. If you don't have a conservation buffer, you get more regulatory scrutiny, you can't offer dividend payments, etc. In other words, you'll want a conservation buffer.

Then there's the "countercyclical buffer." If credit is growing faster than the economy, banks have to keep as much as another 2.5 percent of common equity. So if all this was in place and enforced in 2006, banks would have needed 9.5 percent of common equity in 2006. If they'd had it, the economy would be in a much better place right now.

This agreement is supposed to phase in over the next eight years. Some people are worried about that, but I think it wise: The best time for banks to have high capital requirements is right before a crisis, but the worst time is right after one. If banks have to raise capital, they don't make loans. And if they don't make loans, the economy can't recover. We're actually seeing a bit of that now, so I'm happy to see Basel move slowly.

more

More here.


Updated to add: The Meaning of Basel: Cohen, Spillenkothen, Stiglitz Speak Out

<...>

Simon Johnson

“They couldn’t do nothing after the greatest financial crisis since World War II, so they ended up doing the minimum. Even people I know who are pessimistic about the process are going to be disappointed.”

“You should have gotten to 15 percent one way or another,” he said of capital requirements. “When times are good you should have capital requirements up to 20 percent.”

“This is not contractionary if you raise capital in the right way. If you tell people to target the ratio, then yes they may shrink the asset side of their balance sheet but if you make them raise capital, which is what they did in the U.S. after the stress test, then that is not at all contractionary.”

<...>

Joseph E. Stiglitz

“It’s a move in the right direction. One should see these actions as part of trying to correct what is clearly a dysfunctional banking sector.”

“While it’s understandable, given the weaknesses and the failings of the banking system, that one would want to be slow in introducing these increased capital requirements, delay is exposing the public to continued risk. Given the high levels of payouts in bonuses and dividends, it seems a little unconscionable to continue putting the public at risk with an argument that they cannot more rapidly increase their own capital.”

“The banks have complained about the fact that increased capital adequacy requirements of this kind would increase the cost of capital that firms would have to pay. But one should recognize that through the bailouts that have been repeated all through the world, not just during this crisis, the public has in effect been subsidizing the banking sector and that represents a very large distortion in the financial system. If the cost of capital is higher as a result, it’s just undoing a distortionary subsidy.”

<...>

Summary: Johnson believes 11 percent is the minimun, that it should have gone from 2 percent to at least 15 percent. Stiglitz says it's step in the right direction, undoing a "distortionary subsidy," but he is concerned about the implementation time frame.

[ProSense]

1. No comment?

A financial agreement is reached, one that will have a significant impact on financial reform, and no interest?