Opinion: Hold off on the Basel Accords

We can shortly expect the world’s central banks and finance ministries to reveal new standards for capital adequancy (also known as the Basel III accords). What is most notable about the accords is how quickly they’ve been drafted in light of the failure of Basel II, which was finalized in 2004 and we all know how well that worked out. Many are arguing that the new accords will likely benefit global banking and create more stability, but I think this is somewhat simplistic.

Primarily, the impact of the previous rules (“Basel II” in 2004) was to encourage greater reliance on statistical techniques for analyzing risk and increased reliance on derivatives by banking institutions. There is very little disagreement that the financial sector became overly exposed to both in the following years.. In light of the problems that occurred under the Basel II regime, it seems premature to sign the Basel III accords when it remains very much in debate as to what the causes and consequences were of the global financial crisis. Indeed, it would appear that European financial institutions remain excessively exposed to certain types of risk (particularly Mediterranean sovereign debt), and historically, this has proved problematic.

As several economists, including Eric Rosengren, pointed out in the 1990s, there is powerful evidence that the impact of the Basel I accord was to compel Japanese banks to reduce their exposure to real estate assets and curtail real estate lending in the late 1990s. It’s difficult not to associate this with the collapse of the Japanese real estate bubble and the country’s subsequent super-recession.

My point is not that I expect the passage of Basel III to cause a collapse in real estate values or encourage risky lending practices, but rather to illuminate the unintended consequences of universal banking regulation and standards. Undoubtedly, had the Japanese negotiators at the first Basel accord been aware of the risks the new rules on Tier 1 and 2 capital would have had on their domestic banking industry, they would have been more effective at reducing it’s impact. But, they didn’t see it coming. This isn’t because the Japanese are bad bankers (they aren’t) or because they’re terrible negotiators in international contexts (they are), but rather because they didn’t see it coming.

Basel I was bitterly negotiated, and at several points the British and American parties threatened to negotiate their own agreements and then impose them on any banks wishing to do business within their borders – this produced policy that had asymmetric consequences. British and American banks ultimately benefitted and Japanese banks suffered. In the late 1980s, the world’s largest banks were Japanese. By the end of the 1990s, the US, Britain and Switzerland were the dominant players.

In contrast Basel II struck me as a more friendly affair. The consequences seemed to be symmetric – virtually all the world’s banks seemed to be overextended and overrun with statistics in it’s wake.

But the results of both had consequences for hundreds of millions of people and influenced the direction of whole economies. It seems to me that there will be both good and bad that emerges from any new banking regime and the consequences are so far extending that any reasonable regulatory process should be imposed in a more deliberate manner. And only after we can definitively state that the current financial crisis is over.