Basel Deal Done: New Bank Capital Requirements Set

In the run-up to the financial reform debate there was much discussion of how to make sure Wall Street was prevented from engineering the next financial meltdown. While some argued that the Dodd-Frank law did not adequately spell out what was required of the big banks going forward, the response of the Obama administration was that they saw capital requirements as a major tool in the arsenal, ready to be deployed. If banks had to hold higher levels of assets on their books, they could cover their own loses and be forced to limit their exposure and risks.

When pressed as to whether these levels should be specific directly in the law, the administration highlighted the discretionary role of the new Oversight Council which could mandate these levels and the importance of negotiating these standards internationally. Given the interconnectedness of the global economy and the desire not needlessly disadvantage US firm, this approach made since as long as there was the possibility of a unified action that would spread across borders.

Well, it looks like the negotiations in Basel Switzerland have wrapped up their work. The headlines this morning announced an agreement of the Basel Committee on Banking Supervision to effectively triple the capital reserves of large banking institutions.

I believe this is a serious and meaningful step in the process of reforming the financial sector and making it more resilient to financial shocks. It is also another major achievement for the Obama administration, since this is the outcome they had been advocating from the beginning. Not sure if this will help them politically since policy gains don’t seem to matter much to the punditry these days.

Here is Tim Fernholz, providing a bit more of the summary:

Yesterday, in far-off Basel, Switzerland, technocrats from countries around the world — including the G-20 countries and the United States — agreed to new international banking standards. This process needed to take place on the international stage — and apply to countries across the board — because unless standards are universal, we could see some pernicious business practices migrate to the least-regulated parts of the world. The essential take-away from this process is that governments agreed that banks will need to hold more than double their “common equity” — straightforward ownership stakes, including capital that is less straightforward, like preferred stock, the requirement for more loosely defined “Tier 1” capital increases by a third, so that banks must hold total capital of 8 percent.

Also interesting: Banks must maintain a “capital conservation buffer” that prevents them from paying out dividends or taking other steps that would reduce their capitalization when their capital ratios are within 2.5 percent of the minimum requirement, so many banks will need to maintain a total capital ratio of 10.5 percent capital to liabilities; this is much higher than most banks carried during the crisis and higher than what many banks are carrying now.

Finally, there is also a countercyclical capital requirement that national regulators can apply of up to 2.5 percent of capital that would help deter the problems that come with the increased risk of a bubble as an economy heats up. That would mean that regulators would have to take note of the kind of conditions we saw in 2005-2007 and ask banks to hold more capital; while regulators’ ability to spot a bubble is certainly widely debated (with answers ranging from they can’t, they can but they won’t, they could but they’re too dumb/pernicious), at least this is a mandate for them to account for the kind of indicators at least some economists recognized in the run-up to the final crisis.