Over the weekend, a small committee gathered in the small city of Basel, Switzerland, to propose policies governing the largest and most powerful financial institutions in the world, all in the hopes of averting another financial cataclysm like that of 2008. The measures they announced were discouraging.
First some context is in order. In 2010, Basel III, as the latest international agreement is called, proposed for the first time a minimum capital reserve requirement for global systemically important banks, those Too Big to Fail. As Anat Admati and Martin Hellwig explain in remarkable layman’s terms in their 2013 book The Banker’s New Clothes, minimum capital requirements are both the simplest and most effective way of shoring up our financial system by bluntly forcing banks to become more failure-resistant. Admati and Hellwig call for a 10 percent reserve requirement to shore up the biggest banks, but Basel III only set a 3 percent limit.
To use the apt metaphor of The Banker’s New Clothes, this is roughly equivalent to buying a house with 3 percent down, the rest financed by debt, a mortgage in this case. One only has to ask homeowners who weathered (or didn’t) the 2007-2008 real estate crash to realize how little a home’s value has to fall in order to send a property purchased with a mere 3 percent down underwater. Still, it was a start. Unfortunately, the 2010 committee went on to water that 3 percent down further by giving banks a variety of ways to reduce the denominator involved in calculating the amount of which they had to hold some in reserve, for instance by not counting many of the riskiest derivative assets that U.S. banks in particular keep off their books.
In June 2013, the Basel Committee proposed guidelines that kept the paltry 3 percent reserve requirement, but stiffened the drink of that denominator. The committee bravely floated guidelines that would require banks to count their off-sheet assets, such as derivatives, among the liabilities they would hold equity assets against. Then the banks’ lobbying began. Over this past weekend, the final guidelines were released, containing an array of weakening measures, allowing the banks to once again reduce what they would have to count. For those interested in the particulars, I highly recommend Mayra Rodriguez Valladares for the inside baseball, or Matt Yglesias’s fine account for the general reader.
The last point I want to make here is one that Yglesias also harps on, because it is one of the most common and misleading arguments the banks and their media sympathizers use to try and fend off fairly common-sense regulations. Banks will argue that they should not be subject to increased capital requirements, because holding more capital means they will have less to lend, slowing economic growth in a particularly weak economy. This is nothing more than slight of hand. Increased capital requirements merely demand that they finance their liabilities with cash or equity, rather than money they themselves borrowed that exposes them to further risk. For a more extensive and thorough explanation, I cannot recommend Admati and Hellwig’s book The Banker’s New Clothes highly enough. It manages to explain the situation without any more math than looking at a mortgage.
As Yglesias says, the next fight happens in the coming months as our domestic financial regulators decide how to adopt or implement the Basel guidelines. Let’s hope they show more mettle than the Swiss committee.
EDIT: Now that Noah Millman, our resident former Wall Street derivatives man and theatre critic, has weighed in, you should go read him now.