Can Basel III Be Saved?

WASHINGTON — There is increasing concern that the Basel III accord may be teetering on the edge of a breakdown as the gap between those countries that are pressing ahead and those that are not continues to widen.

But there is still some hope to save the process, if regulators show a willingness to accept the reality that true harmonization is likely unachievable, according to a new paper released Friday by Karen Shaw Petrou, a managing partner at Federal Financial Analytics Inc.

"We are just not going to have a globally harmonious, hands-across-the-sea financial services regime in which everybody is as good as good can be," Petrou said in an interview. "It's time to start a conversation on Plan B. Plan A is not working. Everybody doing Plan A will privately tell you they know it's not working."

Thus far, regulators' Plan B has been to give the Financial Stability Board more authority to try to force nations to comply with the standards. But the FSB has largely proven unable to get all participating countries to cooperate.

Petrou argues for a radical shift in thinking, saying regulators should forgo the idea of a standard set of rules across nations. She points to their differing banking structures and the increased likelihood that each country will simply adopt rules in their own best interest.

Unless supervisors change direction, Petrou says they risk undermining the integrity of the international regulatory system and ultimately reverting to a far less stringent system.

"We need a better model or we will go back to the lowest common dominator regulation and that is systemically, macroeconomically dangerous and it's competitively bad for the United States, because we will have a tough regime," she said.

Under the Dodd-Frank Act, for example, U.S. regulators are banned from using credit ratings to help set capital requirements. Domestic banks may also face higher capital requirements than their international counterparts due to a tougher leverage requirement and risk weighting standards.

International banks, meanwhile, face no such restrictions — and the gap between U.S. banks and their overseas competitor may continue to grow larger.

Regulators are expected to unveil new liquidity rules under Basel III as early as this week. While the U.S. is likely to adopt them, some other countries may not—or may weaken them in implementation.

To be sure, U.S. regulators led by Federal Reserve Board Gov. Daniel Tarullo have consistently urged members of the Basel Committee to keep their promises to implement the rules as specified under the global agreement.

But Petrou says such cajoling won't be enough to prevent a Basel breakdown.

"If global regulators fail to recognize this hard reality, they could well become the financial-market equivalent of all of the United Nations agencies that issue lengthy protocols and proclamations ignored in form and substance around the world even as signatories dutifully pen their names," she writes in the paper.

Instead, she says policymakers should codify global standards "not as hoped-for rules," but as "best practices" for the industry, which rely on clear quantitative standards and qualitative criteria to ensure that each country and every financial institution can be evaluated objectively.

The FSB should also continue to improve its peer review process, which holds all countries accountable to their progress in implementing Basel III. Instead of trying to shame or put pressure on countries that lag behind, however, Petrou says its emphasis should be on alerting supervisors of pockets of risk if a particular country is falling short on capital or other supervisory standards.

Each regulator could then ultimately decide whether or not to engage with that particular nation or financial firms from that home country.

Petrou is essentially proposing for the financial services industry the equivalent of international air safety standards. Just as countries have binding agreements on airline safety agreeing to enforce a common set of standards, they maintain legal authority to keep out airlines that don't meet such thresholds. The financial services industry, Petrou says, should be able to do the same — something she calls "trade-in financial services standards."

Domestic regulators would be free to set their own national standards, but other countries may apply safeguards if those are seen as insufficient. Such safeguards could include barriers to entry or entry granted on a conditional basis.

It's a fresh idea; one that Petrou hopes will spark a debate on what regulators need to do to salvage Basel III.

"The trade-in-goods analogy to the trade-in-financial services may not be the right answer," said Petrou. "But if it isn't this, then what? Because if it isn't this; then it's just going to be continued disintegration of the global framework."

The risk of such an approach is that countries may adopt protectionist practices if a trade-in financial services regime were to be applied — an outcome Petrou opposes.

She says the Basel Committee, FSB, and International Monetary Fund should work on identifying key criteria for fair and prudent trading in banking. These institutions, she says, should also work to improve or replace the World Trade Organization's trade-in-financial-services provisions to make them more transparent, enforceable and focused on prudential factors.

Regulators should also continue to pursue effective cross-border banking resolution regimes in order to handle the potential collapse of a systemically important institution that operates across multiple countries.

"This is the one area where we need fiat for cross-border bank resolution, where regulators engage in binding agreements," said Petrou.

The onus is not completely on regulators to begin to think strategically, she said. Financial institutions also need to think critically about the state of play.

The first decision financial firms need to make is to figure out whether they want a "harmonized or heterogeneous regulatory framework," Petrou writes.

"Those in the industry who believe it to be in their interest in fact to see such an outcome must decide not only if industry agreement is viable, but also if sufficient momentum for it can quickly be amassed to reverse the ongoing, increasingly rapid disintegration of global rules," Petrou writes.

They also need to weigh the degree to which fair trade-in-financial services would permit adjustments to global rules to meet their objectives without exposing them or the markets they operate in to undue risk of regulatory arbitrage.

Lastly, banks should make it a priority to take an inventory of rules they think are warranted in home and host countries, rather than applying their current "just-say-no" policy.

"I really understand why everybody has been so focused on that because it's been an avalanche of rules that people are really buried under," said Petrou. "I think leaders of banking need Plan B, particularly in the United States, because if we don't have a credible Plan B we go back to that island-state banking system risk, which is not good for these institutions from a competitiveness and profit perspective."