Up Front

Another Big Step Forward for the Basel III Bank Capital Proposals

Douglas J. Elliott

The crucial project to strengthen bank capital standards, known as Basel III, moved forward another big step yesterday, virtually ensuring that the rules will be completed in time for the G-20’s Seoul meeting in November. This matters because capital represents the key safety margin for a bank; the last crisis would likely have been significantly less harsh if capital requirements had been higher.

The Basel III process is making capital levels safer in three ways. (Please see my earlier paper, “Basel III, the Banks, and the Economy,” for more information.) First, softer forms of capital that provide less protection would largely be replaced with common stock, by far the strongest form of capital. Second, numerous technical changes would increase the total amount of capital needed to cover a given type of risk. Both of these sets of changes were already largely agreed upon in earlier rounds of discussion.

The final key step took place in Basel over the weekend. Central bankers and regulators agreed on the specific levels that banks will have to meet for the capital ratios. Common equity will need to equal 4.5% of the size of a bank’s assets, (with this size adjusted up or down based on the riskiness of the assets). An additional 2.5% will also need to be in place as a “conservation buffer.” Banks will be allowed to have a lower buffer than 2.5%, but only under the penalty that they must hold down compensation and withhold dividends until the buffer is restored. Regulators will be allowed to impose another type of buffer on top of this when they see a risky boom in credit taking place, but this is left to national regulators as the Basel participants could not yet agree on a uniform approach.

The 7% level (4.5% plus 2.5%) is a bit lower than I’d like to see, but is much higher than the effective requirement of 2-3% that currently exists. International standards require a so-called Tier 1 capital ratio of at least 4%, but half of this could be in softer forms of capital, leaving a requirement that common equity be at least at the 2% level. The U.S. rules were similar for “adequate capitalization,” but banks faced some penalties unless they were at the higher “well-capitalized” level of 6% Tier 1 capital. There was no hard and fast rule as to how much of this needed to be in common stock, but the general belief was that it could be around half, putting it at the 3% level.

One piece of good news is that the U.S. banking system should be able to meet these levels without great difficulty. Most of the largest banks that dominate our system are already there. Since the rules provide quite generous transitional arrangements that give banks as much as eight years to meet the requirements, this should not be a serious strain on the system.

Some bankers have argued that Basel III will force credit conditions to tighten significantly, but my analyses show that the effect should be relatively small. Other academic analyses, and that of the folks in Basel, come to the same conclusion. There will be some tightening, which may slow the economy slightly, but the improved safety of the financial system is worth that modest price.