by Don Alexander, MBA
Associate, RSD Solutions Inc.
Paul Atkinson and Adrian Blundell-Wignall, in a second VOXEU communique (Feb 29th) suggest that further reforms are needed to change and simplify of Basel III capital rules.
Atkinson and Blundell-Wignall note that the design in the Basel framework for regulating bank capital adequacy has resulted in a “vast, poorly diversified, highly interconnected banking system” supported by a far too-small capital base. The system is inflexible to adjust to external shocks, so local problems can become systemic. They suggest the system can be placed on a firmer foundation by the following changes: (1) simplification of capital requirements; (2) realistic and less complex financial supervision; and (3) more reliance on market discipline.
The authors suggest that a risk-weight system for capital charges be replaced by a leverage ratio with an upper limit. This includes reporting of gross derivative positions, according to international accounting standards, in the asset base that require equity support without the distortions using netting permitted GAAP reporting rules for calculating capital charges (not always zero risk). Otherwise, Basel III capital rules may produce outcomes that are less stable. Bank activities should be separated into low-risk and high-risk activities (through separate subsidiaries – legal vehicles) to limit equity base exposure to losses from any single activity (trading). This allows each subsidiary to have its own equity base while limiting government guarantee programs to specific activities such as retail banking—but not derivative trading. This eliminates the cross-subsidization of other activities and makes the banking system less vulnerable to shocks.
Liquidity management rules serve little purpose and should be replaced with a better capital-adequacy framework and resolution structure. There are limits to supervisor’s abilities and resources which places limits on what they can accomplish. This might suggest simplification of the regulatory structure and strive for accident prevention rather than micro management of large, complex financial institutions.
Lastly, there is a need to simplify and reduce bank interconnectedness to increase the reliance on market discipline. This would allow large creditors that provide a much larger fraction of bank funding than shareholders, to be exposed to losses for their mistakes. This combined with the leverage limits might reduce reliance on wholesale funding and trading activity. The simplification of the complex bank interconnections could lower counterparty vulnerability to systemic risk. The idea is to reduce the too-big-to-fail syndrome and the implicit guarantee that is associated with it. Large bank creditors are exposed to more losses and may help limit government exposure to those activities that require high levels of capital support.
The failure to identify and mitigate the risks left by Basel III could be a costly mistake.
For more on this, follow the link: www.voxeu.org/index.php?q=node/7678
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