Basel III Is Still Bonkers

It's been two days, and the new Basel III bank regulations are still lousy. Martin Wolf slams the international banking accord here [1] and Yves Smith agrees here [2], although Felix Salmon notes some improvements over the current banking regime here [3] and Tim Fernholz offers a full-throated cheer for the new rules here [4].

What makes the new rules so unnerving? Martin Wolf nails it. First, as I emphasized on Monday [5], he says that the only real line of defense Basel III deploys involves risk-weighted capital, and risk-weighting can be gamed. More importantly, the new capital requirements just aren't anywhere near the levels needed to rein in banks that know they have access to unlimited government support. We haven't fixed too-big-to-fail, the banks know it, and as a result, we'll need much, much higher levels of capital than Basel III actually demands.

How much more capital? Wolf says 20 percent to 30 percent, without risk-weightings. What does Basel III actually deliver? A paltry 3 percent. As I noted on Monday [5], that's equivalent to a leverage ratio of 33-to-1, actually higher than the 31-to-1 leverage Lehman Brothers deployed at the peak of its crisis-era excess.

What's worse, this hard leverage cap is only a test. In a few years, the Basel committee will reconvene to determine whether such measures are even necessary. I can foresee only two possible outcomes. First, the global economy has suffered another major financial calamity and all will agree that the cap must be higher—this should be unacceptable. In the second, the economy is improving, the banks are making lots of money, and regulators agree that silly things like leverage caps are a relic of the past, an overreaction to a crisis that the world has moved on from, nevermind the millions of jobs lost and careers ruined in the process. Nobody is going to suggest moving the cap to 5 percent, much less 20. Catastrophe quickly ensues.

Felix Salmon [3] acknowledges that the risk-weighting issue remains problem, but still sees reason to be "unapologetically happy and optimistic." Whatever it's flaws, Basel III is still better than what we've got now—this is unquestionably true, by the way—and besides, Basel III also features new liquidity rules, which will help keep catastrophes like Lehman from developing, so things aren't really that bad. Basel II included no liquidity constraints, which was certainly a mistake.

This is the general consensus on Lehman's collapse, but it's not really accurate. Lehman did experience a massive run immediately before its failure, but the Federal Reserve had already given the bank access to its discount window. The whole purpose of the discount window was to provide liquidity in the face of a bank run. But the Fed didn't lend to Lehman, because Lehman didn't have the collateral to support such a loan. In other words, Lehman wasn't just shy on liquidity, it was insolvent.

Moreover, there's a reason why investors pulled the plug on Lehman in the first place. The bank was totally overleveraged, and had invested in absolute garbage. Lehman knew it was overleveraged, and knew that the market was concerned, which is why it resorted to a complicated derivatives scam of dubious legality in order to hide a mountain of debt from its investors.

Sure, tighter liquidity rules are better than no liquidity rules at all. But without major capital requirements, banks are going to be prone to massive runs, and when the market reaches its verdict on a bank's viability, all the liquidity in the world won't stop the run. When Bear Stearns went down, investors wouldn't even accept U.S. Treasury bonds as collateral. No regulatory measures can overcome such a panic.

The key is to prevent the panic in the first place, and make sure that the consequences of the panic do not overwhelm the broader economy. At an absolute minimum, that means stringent capital requirements. Tim Fernholz thinks Basel III delivers the goods [4], calling the accord "a tough new international regime" and "a rare sign of optimism in the battle with the banks."

I just can't understand that view. My point is not that Basel III is worthless—it's very clearly a step in the right direction. But this is the structural response to the worst financial crisis in history. Given that backdrop, Basel III is laughably weak.

This was not the savings and loan crisis. Every major U.S. bank other than Lehman Brothers had to be bailed out on a massive scale, and bank bailouts in Europe sparked a string of sovereign debt crises that almost toppled the Euro. As a result of this enormous economic catastrophe, international regulators plan to bump up risk-weighted capital minimums from 4 percent to 7 percent (Basel II was 2 percent, but the U.S. implemented 4 percent) and acknowledge that liquidity can sometimes be a problem. This is akin to a doctor telling an alcoholic to keep drinking, but start taking vitamins. After he's suffered a heart attack.

Salmon says that critics who demand that Basel III prevent the next crisis are asking too much. Whatever the regulatory regime, he says, financial crisis are always possible. It's true-- we cannot predict the unforeseeable. But this truth is also meaningless. We can take measures to ensure that whatever crisis may come is not a global economic disaster, we can ensure that the cost of cleaning it up is low, and we can ensure that the costs to the broader economy are contained. Basel III falls short on all three of these goals. What's worse, all three of them are attainable.