Research
Basel III and the “Paradox of Financial Instability”
Written by Richard Reid
As the pressure mounts on the Financial Stability Board to come up with workable recommendations to the G20 on reform of the financial regulatory framework, it’s worth taking a close look at this recent speech by the BIS Deputy General Manager Hervé Hannoun. It is a very considered and detailed description not only about the need for an enhanced framework but also of the means by which it can be achieved. As perhaps might be expected of someone close to Financial Stability Board (FSB) discussions, Mr Hannoun is at pains to point out that any discussion of taxation of banks should not deflect attention from the need to raise capital requirements:
“A number of proposals have been floated on ways for the financial sector to self-insure against a future crisis. Work is under way at the IMF on global bank taxation. One-off taxes or levies on the financial sector could be used to repay the taxpayer money used in bank bailouts, or to finance a banking sector resolution fund. This second approach, which was proposed by several leading bankers but is not presently being considered in international forums, poses a high risk of moral hazard. The financial industry should therefore be under no illusion that these taxes could substitute for higher capital requirements.”
As part of his introductory remarks Mr Hannoun referred to the need to address a situation that is not uncommon for policy makers and regulators, namely one in which the financial system looks strongest exactly when it is at its most vulnerable, or as he says it is called within the BIS, the “paradox of financial instability”. Perhaps this is a natural observation for the BIS to make in the wake of the financial crisis which has engulfed much of the global economy in the last couple of years. There have been a number of commentators who have expressed concern that the regulatory authorities could have done more to avoid the calamitous events since 2007. Nevertheless, he makes the argument cogently that a new framework is required before going in to suggest how this might be constructed.
He notes that since the crisis erupted the tendency has been to see the policy response couched in terms of micro and macro prudential responses – indeed he labels an enhanced Basel II combined with a macroprudential overlay as Basel III.(table 1) Addressing the microprudential elements, the enhanced Basel II looks at increases in the quantity and quality of capital (incl the trading book), better risk management and disclosure, higher leverage charges and counterparty credit risk from OTC derivatives. Macroprudential elements cover stability over time (countercyclical capital charges, capital buffers), and point-in-time (systemic) checks, such as capital surcharges for systemically important financial institutions, network interlinkages and CCP infrastructure (a good summary of the proposals to improve the quality of Tier 1 capital are in the article).
Table 1. Enhanced Basel II + macroprudential overlay = Basel III
While giving a thorough explanation of the BIS proposals to change capital requirements Mr Hannoun also clearly acknowledges the limitations of regulations to avoid financial crisis altogether:
“Identifying systemically important financial institutions and requiring them to hold more capital and liquidity will create a financial system that is more resilient. But it will not prevent bank failures. Another important macroprudential policy issue is therefore how we should deal with banks that are “too big to fail”. Given the well known moral hazard problems associated with these financial institutions, it is important for supervisors, central banks and finance ministries to communicate clearly what will happen in future. In particular, there is a widely recognised need to move from bailing out financial institutions to bailing in their shareholders and creditors”.
He then goes on to consider possible policy responses to the moral hazard risk associated with the use of tax payers money to support failing or troubled companies which promote more appropriate incentives and market discipline:
- Effective cross border resolution regimes, colleges of supervisors
- Orderly wind-down procedures, living wills
- Using going-concern contingent capital arrangements
- “haircuts” on unsecured bondholders (i.e. wholesale creditors)
- Safety nets limited to retail depositors
In an interesting passage and one which importantly acknowledges the somewhat different experience of many emerging economies in this crisis in comparison to that of the developed world, Mr Hannoun explicitly notes the successful policy mixes that certain developing economies have been employing for some time now:
“Asian central banks have taken the lead in implementing various macroprudential tools before and following the experience of the 1997 crisis. .... Their knowledge of these tools is particularly rich compared with that of other regions, and their experience provides interesting lessons for other countries”
He highlights the fact that a number of Asian jurisdictions already use countercyclical provisioning, loan-to-value ratios and direct controls on lending to specific sectors to manage procyclicality and address aggregate risk through capital surcharges and liquidity requirements.
Table 2. Experience with macro prudential tools in Asia
Maybe with a view as to how the FSB and the Basel-based committees will position themselves in the face of their G20 duties, Mr Hannoun ends with a neat summary of the existing and new paradigms for financial stability (table 4). At the end of the list is the need for the focus to move from a domestic one to one of greater global coordination. As this year progresses a major task forthe FSB will be to marry the heavily driven domestic regulatory agendas with the broader stated aspirations of G20 cooperation.
Table 3. Existing and New Paradigms for Financial Stability
