Why Basel III Won’t Work

The new bank capital rules for large multinational banks, called Basel III, may seem to set rules that will prevent another global credit catastrophe similar to the one in 2008. But, its full implementation is 10 years off. Ten years is a long time to hold the coalition of 29 nations together as the rules are implemented. Banks in Europe may have to raise hundreds of billion of dollars to meet the new rules while Asian banks may need to do nothing at all.

The agreement states “common equity” needs to be held at a minimum of 7% of assets for internationally active banks. That is much higher than the 2% international standard for most financial firms and the 4% standard in the U.S. The rules will be phased in over 10 years to give banks time to comply

It has been 10 years since the US had its record budget surplus of $230 billion in 2000. Prohibition lasted twelve years in America. The budget and the period during which people in the US could not drink legally illustrate that things can change a great deal over a brief period.

The Basel III pact assumes that the capital markets will remain robust enough for a number of very large banks to raise new money. That may be the case if the capital markets stay the same. More problems with the global economy could change that and capital could return to the sidelines if banks become risky investments. And that day may come. One of the criticisms of the bank stress tests in Europe is that they did not properly take into account the amount of the sovereign debt held by banks. If there are serial defaults among euro zone nations, the balance sheets of financial firms in the region could crumble.

Experts believe that most US banks are past the period when they will have common equity problems. That is only true if the toxic assets still on their balance sheets do not come back to haunt them and if financial reform does not cut to badly into their earnings.

Banks in China are also vulnerable to short-term financial market considerations. The bubble in real estate and the extension of credit to individuals and business that are poor risks could badly damage the banks in the People’s Republic. The central government at least offers a back stop.

All of this is to say that accords among nations that stretch out over years depend on the evolving conditions in those countries and a decade, under those circumstances, could become a long time for Basel III to be implemented.

Douglas A. McIntyre