Basel III introduces a leverage ratio and raises the minimum risk-weighted capital ratios, but it does so using highly arcane formulas, suggesting more insight and accuracy than can possibly be achieved. Where the markets assess, demand and adjust intrinsic risk weights on a daily basis, regulators using Basel look backwards and never catch up.
Even as countries strive to meet the quickly approaching Basel III deadlines, some fairly influential voices in regulatory policy are wondering aloud if the latest Basel guidelines are up to the task. Thomas M. Hoenig, director of the Federal Deposit Insurance Corporation, in a September 14, 2012 address before the American Banker Regulatory Symposium, raised his concerns that Basel III is based on faulty assumptions and processes, and introduces unworkable complications into an already complex system. Hoenig proposes an alternative, a "back to basics" approach he feels would be more easily monitored and enforced, and represent a better measure of a firm's ability to withstand financial adversity.
The poor record of Basel I, II and II.5 is that of a system fundamentally flawed. Basel III is a continuation of these efforts, but with more complexity. It also is more prolific since it applies across all banking firms.
. . .
In private discussions I find a good deal of uneasiness about Basel III’s ability to be more effective than previous Basel efforts; however, there is a sense that we cannot go back. I suggest that we not only can go back, we must.
Hoenig suggests that Basel and regulators around the globe scrap Basel III capital requirements and start from scratch. He proposes an alternative he calls
tangible equity to tangible assets ratio: equity without add-ons such as good will, minority interests, deferred taxes or other accounting entries that disappear in a crisis, divided by tangible assets (all assets less the intangibles). This simple ratio does not attempt to differentiate risks among assets, does not tier them into any number of refined levels, and there is no governmental ex-ante endorsement of risk assets or capital allocations. Instead, this simple but fundamentally stronger tangible capital measure:
- is a demanding minimum capital requirement within which management must allocate resources within the overall capital constraint;
- accepts that firms quickly shift their allocation of assets to take advantage of changing risks and rewards;
- reflects in clear terms the losses that a bank can absorb before it fails and regardless of how risks shift. It provides a consistent and comparable measure across firms.
Hoenig is convinced that much of Basel III's complexity arises from the conflicts intrinsic to the combination of commercial banking and broker-dealer activities. He feels that the enormous subsidy created by the safety net encourages ever-greater risk taking as firms attempt to achieve a higher return on equity than would otherwise accrue from commercial banking. He feels that, in addition to capital reserve requirements, a fundamental restructuring separating banking from trading activities is required.
The safety net’s subsidy facilitates the use of leverage and provides an incentive toward higher risks that are hidden in opaque instruments, in trading activities and in derivatives. It bestows an advantage to subsidized firms not afforded others. Solving this problem requires a fundamental restructuring that separates banking from trading activities.
In Hoenig's opinion, Basel III rests on a mistaken notion that that the safety net subsidy can be neutralized, and that risks and shifting risks can be captured, measured and properly and quickly capitalized using financial models. In Hoenig's opinion that markets move too quickly, and the financial system is too dynamic for any Basel model to accomplish this objective. He made it clear that the path leading to the best outcomes for the safety of the financial system is to revisit Basel III and adopt a more basic and transparent approach.
I believe the Committee should agree to delay implementation and revisit the proposal. Absent that, the United States should not implement Basel III, but reject the Basel approach to capital and go back to the basics. By doing so, we can focus on efforts that will create a well-managed, well-capitalized, well-regulated financial system that actually supports economic growth.