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To: Peter Dierks who wrote (44566)	8/1/2010 3:20:15 AM
From: Peter Dierks	Respond to of 71588

Basel-III will not Save Us e21 team \| July 28, 2010 Lutz-R. Frank The finance reform bill has passed Congress without meaningful restrictions on capital and liquidity. As this blog has pointed out, the bill does not affect the agency problems within large financial institutions, and leaves crucial issues of risk management and firm closure to the discretion of regulators. Thus, in terms of narrowly tackling the problems that led to the present crisis, the law clearly misses the mark. Proponents of the measure, like Treasury Secretary Tim Geithner, defended it by saying that an international agreement in the form of Basel-III will handle many of these problems. And, that this bill was designed to give us some tools we wish we had in 2008. Of course, it would be nicer to make the extraordinary events of 2008 less likely, rather than simply empowering regulators to deal with the occasional financial collapse, as they see fit. At The New York Times, Matthew Saltmarsh, Eric Dash, and Nelson Schwartz have reported on the ongoing Basel-III negotiations. Unfortunately, they also appear to be a disappointment. There are two crucial issues here: 1. Leverage Restrictions. As Raghuram Rajan, former chief economist at the IMF, has argued: our understanding of the sources of systemic financial risk remains weak. But most experts and economists will agree that the overall degree of leverage carried by a financial institution is important in determining its risk and probability of failure. Highly levered banks are risky because they are very sensitive to movements in asset prices and economic conditions. Because levered banks do not hold large amounts of capital on hand, even minor losses will force asset sales in order to meet creditor demands, which lower markets further, and force additional fire-sale losses. These asset spirals, in large part, explain the fragility and suddenness of the collapse of some financial institutions in 2008. Consistent rules on leverage require firms to hold a sizable form capital as a buffer against potential losses. Unfortunately, the restrictions proposed in Basel-III are extremely weak. Banks would only be required to hold 3 dollars in capital for every 100 they lend, resulting in a leverage ratio of 33:1. This is higher than most American banks already operate, and is higher than the limits imposed on investment banks during the crisis. 2. Capital Restrictions. The type of capital banks hold is also subject to Basel regulation. The general idea is to ensure that banks hold on to substantial amounts of high quality capital on their balance sheets to stem short-run financing problems. Unfortunately, these capital requirements are highly vulnerable to abuse. For instance, as Steve Waldman has pointed out, Lehman Brothers had a sizable amount of “Tier 1 Capital” right before it filed for bankruptcy. Ongoing negotiations for Basel-III suggest this issue will get worse. Due to lobbying from banks all over the world, regulatory-required capital is likely to include all sorts of financial assets – such as future tax deductions, and stakes in other financial institutions. (Also see the e21 commentary: When it Comes to Capital, Definitional Issues Loom Large) These financial holdings will not help financial institutions deal with short-term liquidity problems, like with Lehman, and so will enable financial firms to continue operating using risky financing options. One awaits the final word on Basel-III, but a preliminary look is highly discouraging. New international norms on prudential regulation are simply insufficient to deal with the sources of financial instability, as poorly as we understand them. Even implementing these weak requirements will likely be an onerous task, just as implementing Basel-II has proved to be (a task which is still ongoing, by the way). Trying to reach a global accord with numerous countries, banks, and regulatory environments is quite simply an extremely difficult task. However, the ongoing failure of Basel-III should be a wake-up call for the Administration, Congress, and the regulators. Despite a highly touted “financial regulation” bill that will be largely useless or counter-productive, the financial regime that we have all but guarantees a future financial collapse – and that should be unacceptable to politicians today. Financial regulatory policy should be based on more than a hope in the wisdom of international accords. economics21.org