Basel III Should Be Scrapped, Hoenig Says

Federal Deposit Insurance Corp. board member Thomas Hoenig has a bold suggestion for regulators crafting Basel III capital rules: start over.

In a speech at American Banker's Regulatory Symposium Friday, Hoenig said that the rules as proposed are too complex and should be replaced by simpler ones that rely primarily on a bank's ratio of tangible equity to tangible assets.

He also suggested that if international regulators do not return to the drawing board, then U.S. regulators should reject Basel III standards and "go back to basics."

"Basel III is intended to be a significant improvement over earlier rules," said Hoenig, a former president of the Federal Reserve Bank of Kansas City. "It does attempt to increase capital, but it does so using highly complex modeling tools that rely on a set of subjective, simplifying assumptions to align a firm's capital and risk profiles."

Hoenig has been critical of the proposed rules in the past, but his comments that the Basel Committee on Banking Supervision should delay implementation and revisit the proposal were his most forceful yet.

In his prepared comments, he said prior Basel rules did nothing to prevent the most recent financial crisis and that Basel III would do little to prevent the next one because it does not account for the fact that market conditions change. For example, he noted that regulators knew well in advance of the mortgage crisis that the risk on home loans had increased between 2005 and 2007 yet no changes were made to risk weights of those loans.

"Whereas the markets assess, demand and adjust intrinsic risk weights on a daily basis, regulators using Basel look backwards and never catch up," he said.

He also said the proposed rules, which are scheduled to be phased in starting next year, would put smaller firms with fewer resources at a competitive disadvantage.

"Directors and managers will have a steep learning curve as they attempt to implement these expanded rules," he said. "They will delegate the task of compliance to the technical experts, and the most brazen and connected banks with the smartest experts will game the system."

As currently proposed, the rules would require banks to hold specific levels of capital against certain assets such as mortgages and construction loans.

Hoenig urged international banking regulators to adopt a regime based on tangible equity, which he said is a measure that simply demands a minimum capital requirement that gives management the flexibility to shift allocations of assets to "take advantage of changing risks and rewards."

He also said that the starting point for any discussion of acceptable level of tangible equity should be "well above" the 3.25% level now implied by the Basel III proposal. In a follow-up interview, he said debate for what is the right level of capital should start at 10% and that he would hope it would be set even higher.

"Capital is the foundation on which a bank's balance sheet is built," Hoenig said in his prepared remarks. "There can be no fortress balance sheet without fortress capital."

Critics of his plan might argue that it would reduce overall liquidity in the market and thus restrain, economic growth, but Hoenig disagrees. Banks all but stopped lending following the financial crisis, and he said that would not have been the case had they had adequate levels of capital to begin with.

Hoenig acknowledged in a follow-up interview that the rulemaking process might be too far along to be reversed, but if it is implemented he would strongly urge the U.S. not to go along. "As a leader," the U.S. "should take this in the direction I'm suggesting because we will have a safer banking system."

Hoenig also used the speech and the follow-up question-and-answer session with American Banker Editor at Large Barbara Rehm, to press for the separation of commercial and investment banking. While he believes that investment banking plays a crucial role in the economy, he says it needs to operate the "safety net" of government-supported deposit insurance.

In his view, the time to act is now, before the economy fully recovers and any appetite for breaking up large, complex institutions diminishes.

"Do it now, while the case is strong," he said.