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Douglas Elliott on Basel III: 'I am happy, and yes, you should be pleased.'

Since nothing juices traffic quite like blanket coverage of the capital requirements coming out of the Basel III negotiations, here's one more for you: Douglas Elliott, the current director of Brookings' Center on Federal Financial Institutions and a former investment banker with JP Morgan, has been following the proceedings for the past year, and was kind enough to talk me through today's release. Here's a lightly edited transcript. If you want more background, read the previous interview I did with Elliott.

Ezra Klein: So, should I be pleased about the outcome of Basel III? Upset? Confused?

Douglas Elliott: I am happy, and yes, you should be pleased. There are things I would do differently, and they did water things down. But broadly speaking, this is a big step forward. It’s several times as much common equity behind these banks as we do today.

Why should we care about common equity?

Common equity is important because we want someone we don’t care about to take the losses if the banks run into trouble. Common shareholders bought shares of the banks expecting a share of future profits as their reward. We don’t care if they lose money. If depositors to the bank, or the suppliers of funds to the bank, lose money, we do care. If you look at the crisis we just went through, there were rescues to help creditors and depositors, but shareholders took huge losses. And no one other than them was terribly worried about that.

As I understand it, this common equity test performed pretty well in the financial crisis. One of the best ways to predict who would survive and who would fail was to simply look at their common equity, right?

That’s exactly right. You want capital to be strong. There was a belief a few years back that while common equity was the strongest form of capital, there were other things that were almost as good. What we found out in the financial crisis was that that wasn’t true. You really want common equity to be the backbone of your capital base. This would’ve helped the last crisis a lot.

Now, the common-equity requirements are as a percentage of “risk-adjusted assets.” That concerns me more, as we weren’t terribly good at figuring out how risky different assets were.

It’s definitely something to be concerned about. It’s one reason why we want, as a safety net, to have a straight leverage test that looks at total capital to total assets without doing any adjustment. It’s simplistic, but using it in conjunction with the main tests helps you make sure that you’re not seeing everyone load up on one type of asset that they’re saying isn’t risky but actually is. There is a test like that in the plan, though it only requires 3 percent of capital against non-adjusted assets, which is a bit low.

So what happens next? Banks have to raise this equity. Do they begin selling shares?

In practice, the big banks, which dominate the system, already have enough capital without taking any extraordinary measures, as they’ve already been bulking up. The ones who aren’t there yet will just have to keep holding onto the money they earn until they get there. The important thing, however, is that they’ll also have to keep this capital 10 or 15 years from now.

But will they? What force does Basel III have? My understanding is that America didn’t even implement Basel II. So what’s to stop us from just ignoring it in 15 years?

No, we didn’t, in the U.S., implement Basel II. We might have eventually. Part of the problem was we were pretty relaxed about risk [in 2004, when Basel II was released]. But once you get something enshrined in international agreements and then put into national regulations, it’s a lot harder to wear it away. That can still happen, of course. We could do something stupid 20 years from now. All you can do is set up the structure, make clear why you’ve set it up that way, and underline its importance.

And so that’s what happens next: The regulators actually write this down in their big book o’ regulations, and so it’s actually in writing in the regulatory books of the different countries? This isn’t just a white paper, right?

Absolutely. We do it by acts of the regulators who will go through and formally make it active. In many other parts of the world, they put it into law rather than into the regulations.

Which do you prefer?

There are pros and cons. If you put it into law, it’s harder to tinker with. If it’s in regulation, it’s easier to tinker with.

These new regulations will have an eight-year phase-in period. Some people say that’s too long, but you say that, in most cases, the banks already have the capital. Meanwhile, there are concerns that just as the banks weren’t holding enough capital before the crisis, they’re holding too much now, and that’s slowing their lending and thus our recovery. So how do we balance, on the one hand, the need to have a safer banking system with, on the other, the need to get the banking system moving again?

The capital requirements are by no means the main reason they’re not lending, but we also don’t want to give them a disincentive to making good loans. They have an eight-year transition period, which is more than long enough to get past this recession. If anything, it’s probably a little too long. We do have to recognize that adding margins will slow the economy a bit during good times. But we’re getting a lot more safety for that cost. We don’t want the world economy to blow up every 20 or 30 years. That creates tremendous problems. It’s worth being a little slower in the good years to avoid the really bad years.

You said that the capital requirements aren’t why the banks aren’t lending. In your view, what is?

One, they’re scared. Two, a lot of businesses aren’t looking to borrow money, because they’re scared. Even consumers are cutting back in order to build savings back up. At this point, demand is very weak. And the day-to-day regulatory supervision is full of examiners pushing them to be more careful, not to go out and lend a lot. If you’re a workaday bureaucrat and you’re not tough on lending right now and the bank you’re overseeing blows up, you’re in trouble.

There’s some tension there between the people at the top of the economic-policymaking pyramid and the regulators, right? You hear the top people demanding that the banks stop sitting on all this money, while the regulators are being pretty strict about who they can loan to.

It’s almost unavoidable as a matter of organizational behavior. Bernanke and the others may be saying ‘don’t be too tough on lending,’ but Bernanke isn’t going to come down to your review and say, ‘Don’t worry, I know one of your banks went under, but you were doing what we told you.’

By Ezra Klein  |  September 13, 2010; 5:51 PM ET
Categories:  Financial Regulation , Interviews  
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Comments

Excellent interview, Mr. Klein, believe it or not this is the kind of stuff that draws me to this blog. Keep on reportin'.

Posted by: CarlosXL | September 13, 2010 6:47 PM | Report abuse

The decisions investors make never fail to astonish me. The new Basel iii rules and what investors understood is no exception.

I want to remind investors that:

1. Basel i, ii or iii is a minimum standard. Financial organizations have to keep regulatory capital well above the minimum.

2. It is not over. The announcement yesterday was only the start. We will have more.

3. Countries will ask for more than the minimum. This requirement will become mandatory under Pillar 2 in Basel iii, as it was under Basel ii.

4. You do not have regulatory capital only for regulatory purposes. You do that for the credit rating agencies, the press, and the stock price.

Some of the new rules:

A. Tier 1 Capital

Tier 1 Capital Ratio = 6%
Core Tier 1 Capital Ratio (Common Equity after deductions) = 4.5%
Core Tier 1 Capital Ratio (Common Equity after deductions) before 2013 = 2%, 1st January 2013 = 3.5%, 1st January 2014 = 4%, 1st January 2015 = 4.5%
The difference between the total capital requirement of 8.0% and the Tier 1 requirement can be met with Tier 2 capital.

B. Capital Conservation Buffer

Banks will be required to hold a capital conservation buffer of 2.5% to withstand future periods of stress bringing the total common equity requirements to 7%.
Capital Conservation Buffer of 2.5 percent, on top of Tier 1 capital, will be met with common equity, after the application of deductions.
Capital Conservation Buffer before 2016 = 0%, 1st January 2016 = 0.625%, 1st January 2017 = 1.25%, 1st January 2018 = 1.875%, 1st January 2019 = 2.5%
The purpose of the conservation buffer is to ensure that banks maintain a buffer of capital that can be used to absorb losses during periods of financial and economic stress. While banks are allowed to draw on the buffer during such periods of stress, the closer their regulatory capital ratios approach the minimum requirement, the greater the constraints on earnings distributions.

C. Countercyclical Capital Buffer

A countercyclical buffer within a range of 0% – 2.5% of common equity or other fully loss absorbing capital will be implemented according to national circumstances.
Banks that have a capital ratio that is less than 2.5%, will face restrictions on payouts of dividends, share buybacks and bonuses.

D. Capital for Systemically Important Banks only

Total Regulatory Capital Ratio = [Tier 1 Capital Ratio] + [Capital Conservation Buffer] + [Countercyclical Capital Buffer] + [Capital for Systemically Important Banks]

George Lekatis
President of the Basel ii Compliance Professionals Association (BCPA)
1200 G Street NW Suite 800, Washington DC 20005, USA
Email: lekatis@basel-ii-association.com
Web: www.basel-ii-association.com

Posted by: GeorgeLekatis1 | September 14, 2010 1:55 PM | Report abuse

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