Third time's the charm?

By N.M. | NEW YORK

GIVEN the global nature of banking, there really was no alternative to relying on the Bank for International Settlements as the primary regulatory body addressing the problem of over-leverage. And the agreement announced yesterday does indeed address an important part of the problem, specifically the use of preferred stock and more exotic debt-equity hybrids to boost "Tier 1" bank capital. Going forward, banks are going to be obliged to maintain a much healthier amount of true common equity. Simplicity and transparency on how much equity banks actually have is welcome.

But the instant enthusiasm for the agreement does seem a bit overdone. Most obviously, talking about a new regulatory scheme reducing bank profitability reflects a fundamental misunderstanding of how a competitive economy works. Profit goes to zero in situations of perfect competition. Regulation, by erecting barriers to entry, reduces competition. Those banks who are able to meet the regulatory requirements should be even more profitable than before because of lower competition. Of course, the banking sector as a whole might be less profitable under Basel III than it was before, but only if less capital in aggregate was allocated to the banking sector. Individual banks will still need to attract investors—more common-equity investors than ever, in fact—and those investors will demand a competitive rate of return. No bank regulation can change that.

More important, the new regulatory scheme could fail in several ways. The most serious failure in Basel III is that it doesn't address the principal contribution of Basel II to the last financial crisis, namely, the calculation of risk-weights. One of the key components of Basel II was to increase the amount of capital banks had to hold against riskier assets. Extremely low-risk assets, meanwhile, could be held with very little or even no capital. Risk, moreover, was calculated primarily by reference to the rating assigned by one of the recognised ratings agencies. The consequence of this Basel II reform was to discourage banks from lending to risky enterprises, and to encourage the accumulation of apparently risk-free assets. This was a primary contributor to the structured finance craze, as securitisation was a way to "manufacture" apparently risk-free assets out of risky pools. What brought banks like Citigroup and Bank of America to their knees wasn't direct exposure to sub-prime loans, but exposure to triple-A-rated debt backed by pools of such loans, debt which turned out not to be risk-free at all.

Since it did not change this risk-weighting, Basel III effectively doubles down on Basel II. Banks will need to hold more common equity than ever—against their risk-weighted assets. That massively increases the incentive to find low-risk-weight assets with some return, since these assets can be leveraged much more highly than risky assets. Unless I've missed something, lending to AA-rated sovereigns still carries a risk-weight of zero. So one result of Basel III could be to encourage banks to increase their lending to sovereigns at the margins of zero-risk-weight status. If that happens, anyone want to guess where the next crisis will crop up?

The sad truth is that there is no set of rules that will ensure the solvency of the banking system, or its resiliency in a crisis. In a competitive market, banks have no choice but to seize any available opportunity to increase their return on capital. That means that regulators need to be dynamic in their response to changes in the marketplace, and anything that appears to generate returns with low risk should raise a red flag. In other words, if Basel III appears to be working—and banks are lending healthy amounts, generating good returns, and running less risk than ever—that's exactly what should make us worry.