Why you should care about Basel III

Now that Dodd-Frank has passed, there's not a lot of interest in following a meeting of international bank regulators. But Basel III matters -- some argue that it matters more even than Dodd-Frank -- and Brookings's Doug Elliott, author of this primer on the proceedings, will tell you why.

We just passed financial reform. There was a signing ceremony and everything. So why should we care about Basel III? Will it actually matter for our financial system?

It matters immensely. The Dodd-Frank bill was the biggest set of changes in financial reform since the Great Depression, but it’s only half the battle. It leaves many important things to be decided by the regulators. Of those, the most important is the level of capital that banks have to hold in order to deal with the unexpected. The Basel III process is a way of getting countries around the world to agree on how much capital banks will carry. And that’s a tricky balance: On the one hand, we clearly need larger safety margins. We don’t want to have to go through this crisis again. On the other hand, safety margins are expensive. If there are too many, bank loans will become more expensive for consumers.

And who’s at Basel making these decisions? Who does America send?

The Basel Committee is a club of the world’s financial regulators who get together to coordinate their approach, particularly to these safety margins. You have representation from the Federal Reserve, the FDIC and some other bodies. The U.S. regulatory system is a little fragmented.

And why should we trust them? Basel II let banks hold less capital if they had assets that the rating agencies had stamped AAA. Then those assets crashed. Why should we be confident that the Baselites won’t make a similar mistake.

They have a clearer idea now of where the mistakes can be made. They’re adding a simpler measure of the safety margin. The core of the Basel approach is to say we can estimate how risky the loans and investments are that a bank makes, and the riskier the investments, the more you need to hold. That leaves the danger that we might guess wrong, and that the market might be wrong. So they’ll also have a straight leverage ratio, which just says that the amount of capital you have has to be a certain percent of your total loans and assets. And included in that is going to be something for all your off-balance sheet assets. They’ve suggested 3 percent to start.

That sounds extremely low.

I’d like to see the ratio higher than 3 percent, but the ratios traditionally used don’t have off-balance assets in there. So it’s more conservative than it would be if it was just applying to on-balance sheet assets. It’s probably more like 4 or 5 percent.That’s still low but not crazily so. What I hope is that over time they’ll raise that number. The reason they’re not making it tougher to start with and why they’re taking eight years to phase it in is that it’ll have a big effect on European banks. Our regulators already use a simple capital ratio, so this won’t be a huge adjustment for our banks. The Europeans don’t, so their banks hold more assets, but they’re less risky. We have riskier assets, but fewer of them.

How much power do the banks themselves have over this process?

The banks lobby the regulators at Basel, just as they lobby legislators and regulators about other issues. They don’t have any direct control over the decisions, but they’ve spent a lot of time trying to make their case. The banking industry does not like Basel III. They have argued it could slow the economy, and they’ve fought hard on this. The regulators have made some concessions, but they’ve stuck with an approach substantially tougher than the existing rules. The banks would really have preferred something less stringent.

And your calculations have suggested that the banks are overstating their case: Tougher capital requirements won’t do much damage to the economy.

That is correct. I believe these requirements will have a fairly minimal effect. But if you took everything together, you may find the economy slows by a quarter of a percent a year or so. That’s nothing to sneeze at, but if it’s the price we pay to avoid having a massive recession with effects lasting years every few decades, it’s worth it.

And will the regulations be enforced? What’s to stop one country or another from simply ignoring them?

It’s a non-binding, global agreement. So national regulators could decide not to follow it. But in practice, regulators around the world gave been fairly honest about trying to stick with these agreements. The big markets like the U.S. or England or even Europe know that if one part of the world begins regulating too loosely, it can be disaster for the whole system.