Coinciding neatly with the second anniversary of the Lehman Brothers bankruptcy, the Group of Governors and Heads of Supervision, the oversight body of the Basel Committee on Banking Supervision, announced a substantial strengthening of capital requirements on banking entities, known as Basel-3, endorsing the capital and liquidity measures originally proposed in December 2009 and amended in July 2010. The coincidence is all the more remarkable given how much of the proposed measures seem to have been driven by the individual eccentricities of the Lehman meltdown, in the perspective of the much wider canvas of the financial crisis.
Much of the proposed measures are already familiar in India, having gradually been implemented by RBI in the run-up to the events preceding the Lehman cratering. Our financial and economic fortunes will be increasingly tied with the global architecture. Hence, how effective will these proposed measures be at, if not preventing, at least mitigating the effects of the next crisis?
Besides higher capital ratios, the measures propose two new capital buffers?conservation and counter-cyclical?a non-risk weighted leverage ratio (most of the others are risk weighted), new and substantial capital charges for non-cleared derivatives and revisions to the rules on the types of instruments that would qualify as bank capital. In brief, these measures are as follows. An increase in ?Core Tier-1? from the existing 2% of risk weighted assets to 4.5%, this is to comprise ?common equity?, i.e., common shares and retained earnings. Total Tier-1 goes up from 4% to 6%. Total Tier-1 plus 2 capital remains at 8%. Tier-3, used solely for market risk, is completely eliminated. In addition, the capital conservation buffer is 2.5%, consisting only of common equity, and a contingent counter-cyclical buffer ranging from 0.5-2.5% depending on the economic cycle and geography. New liquidity coverage and funding ratios add to this bolster. Specifically, banks? exposures to OTC, i.e., non-exchange traded derivatives, particularly repo, financing operations.
Basel-3 obviously views capital reinforcement as one the principal tools in its arsenal. The other rules address the extensively discussed problematic practices of the global financial system leading to the crisis. Leverage has never been part of the previous Basel regulatory structure, and a non-risk amount of 3% is to be tested over a transition period.
All of these reforms will definitely contribute to preventing a future financial ?Three Alarmer?. But how much of this is likely to fundamentally change the incentives that will shape the financial architecture of the future? Is the increased banking capital sufficient to increase banking strength? (Ethical disclaimer: the following observations are based on publicly available analysis).
The core of the evolving risk mitigation is the basic question whether the Lehman bankruptcy filing was a liquidity or solvency event. Lehman?s then chief had argued strenuously that had the Fed then extended liquidity support, Lehman would have survived, and by a logical extension, substantially dampened the consequent turmoil. The Fed?s decision not to extend a backstop still remains shrouded in mystery, despite the extensive documentation of the examiner?s report and congressional hearings. The Fed by then had opened its discount lending windows to all institutions?commercial as well as investment banks?provided they had good collateral. The fact that the Fed was unwilling to oblige a Lehman bailout pointed to massive problems with the underlying assets.
Why is this distinction important? Because it is related to the measurement of capital relative to risk weighted assets, leading thereafter to the extent of appropriate leveraging. Capital ratios were artificially increased. Simon Johnson and James Kwak have documented this in detail. Lehman, on paper, was more than adequately capitalised, with an 11.6% Tier-1 capital. Unfortunately, at least some of what was described as Tier-I capital turned out to be not so safe. This was partially due to aggressive and misleading accounting. The Repo 105 transactions, for instance, enabled Lehman to move as much as $50 billion off its balance sheet. A rampant use of regulatory arbitrage by many large financial institutions using synthetic securitisations, structured investment vehicles, etc, enables banks to essentially evade capital requirements.
This is also relevant since Basel-3 talks of systemically important banks being subject to higher capital requirements; being ?too big to fail?, they should be particularly safe. But this requires a realistic understanding of the amount of capital needed to withstand a relatively rare financial shock. As we now know, adequacy of capital in Basel-2 was predicated on mathematical models, particularly Value at Risk (VaR), which got ?tails? hopelessly wrong. Methods of calculation of risk weights still remain a holdover from Basel-2. Given these infirmities, should oversight prevent banks from becoming too big or too complex to fail in the first place?
Where do we go from here? The sad truth is that there is no one set of rules that will ensure the solvency of the financial system. Banks will need to hold more ?common equity? than ever, which increases their incentive to find low risk weighted assets with some incremental returns.
Predicting the source of the next crisis is difficult, but one instinctively comes to mind. Sovereigns still enjoy exalted status; lending to AA-rated sovereigns still carries a zero risk weight. One outcome of Basel-3 is to encourage banks to increase lending to sovereigns. No prizes, then, for guessing where the next crisis is likely to start.
The author is senior vice-president, business & economic research, Axis Bank. These are his personal views