Bankers, directly and through their lobbyists, have been expressing outrage related to the Basel III rules designed to ensure the safety and soundness of the global banking system. A top spokesman at the American Bankers Association, for example, was recently quoted saying that Basel III should be "put on a shelf."
Some complain that the capital rules developed by the Basel Committee on Banking Supervision, when integrated into the regulations developed to comply with Dodd-Frank, mean that U.S. financial institutions will be burdened with two sets of capital rules. Others complain that implementing new rules will simply be too onerous for bankers and regulators alike. So they ask: should the U.S. just bail on Basel III?
The answer is no.
Financial crises today are increasingly international in scope and nature. And such complex international problems must be solved cooperatively and globally. The connectedness of the world and the banking system must be acknowledged as a reality that will not go away. We must also appreciate that this global banking integration has resulted in systemic and economic benefits, such as historically cheap capital, increased funds flows and unusually (and likely unsustainable) low interest rates.
Accepting this reality is tough for many in the U.S. Some seem to conveniently and willfully forget the significant role the U.S. played in the recent financial crisis. One of the consequences of the crisis is that the U.S. has, from the point of view of many around the world, lost the regulatory high ground. Until the subprime crisis, the world considered U.S. banking regulations and accounting standards as the starting point for much of their own regulatory oversight. Today, the world looks to the International Accounting Standards Board and the Basel committee for accounting and regulatory oversight. The U.S. needs to come to grips with that.
However, some U.S. financial institutions are suggesting that holding out on Basel III compliance may produce rules and standards more to their liking. But the U.S. can no longer afford to go it alone and assume the world will compliantly follow along as it had done in the past. Indeed, in the future, it will not be possible for the U.S. to have globally prominent financial institutions unless we become cooperative citizens in the global community on regulation, reporting and sound governance.
The rest of the world is embracing both Basel III and international financial reporting (though they also have some serious and substantive concerns). For the U.S., the right question is: How do we accommodate and work within the international system for some appropriately customized modifications that continue to maintain the intent and effectiveness of the global accords?
Doing so requires objectively assessing both the strengths and shortcomings of Basel III. Most important, the framework properly recognizes that all risk assessment must ultimately be tied back to capital. In other words, the only real way to determine capital adequacy is through stress testing and scenario planning that considers all risk elements across the full probability range: the possible, the likely and the probable. Stress testing that reveals both the level and nature of all risk exposures enables bankers to proactively develop contingency plans that address all risks comprehensively and to lay the foundation for continued risk-based capital adequacy and sound governance. In this way, Basel III solves the long overdue problem of trying to get bankers to move from being reactive to being proactive. This approach makes risk-based capital adequacy the predominant guiding force for all business-model decisions.
But while Basel III brings benefits, it has raised some concerns. Critics fear, not without reason, that banks will be less willing and able to make loans due to increased capital needs. We will likely see a rush by banks to have a more liquid balance sheet. Higher liquidity and capital standards will produce a profound change in bank balance sheets, including a move to more shorter-duration assets and fewer longer-term fixed rate loans. Higher cost of capital will mean higher lending rates, not only to compensate for the risk but also to comply with the heightened capital requirement. These factors will make lenders and bankers warier of making loans.
The larger concern with Basel III and Dodd-Frank is that the rules will transform the entire financial service sector into a highly regulated industry that more closely resembles that of utilities. In some ways, Basel III seems to be a move toward a rigid, one-size-fits-all regulatory framework that requires conformity of business models and balance sheets throughout the industry. A utility-sector model may also ultimately require banks to compensate shareholders with higher dividends in lieu of earnings-propelled stock appreciation. In a more risk-averse, regulated environment, paying higher dividends will increasingly be the primary way to attract and retain the capital that is so inherently necessary in the banking system, especially since the new global standards will increase operational costs, further squeeze net interest margins and reduce returns.
Another alarming possibility is the potential that we will end up with multi-tiered and different regulatory rules for non-U.S. global banks; U.S. global banks that are too big to fail; and U.S. tier II to tier IV institutions. Such a patchwork of non-negotiable, non-customized rule sets at three different levels would create a vastly anti-competitive playing field where no institution is really going to win and in which customers and shareholders will be overwhelmed with confusion. Rather, the question posed by different rule sets would be the degree to which different tiers of banks would lose. This is a potential unintended consequence that the industry must address.
How can the primary objective of Basel III — to preserve the safety and soundness of financial institutions at the company and systemic levels — be reconciled with the concerns about over- or uneven regulation? The future of the U.S. banking system is hanging in the balance, so it is essential to find an approach that will safeguard the system and provide a safety net to prevent additional crises.
Moreover, banking customers and shareholders, who have been waiting patiently for answers, deserve an effective, workable solution. Greater transparency in reporting is essential, in order to provide regulators, customers and shareholders with the information they need to evaluate each bank on a stand-alone basis and on a relative basis in terms of safety and soundness. An oversight model with rigid rules and calculations should also be avoided. Instead, there should be principle-based, risk/return oversight that will keep the system sound while facilitating commerce. An effective approach also needs enhanced risk assessment, economic capital, risk-adjusted return on capital and stress testing. The time for action has come.
Orlando B. Hanselman is education programs director of risk and compliance solutions, at Fiserv, Inc.
