One of the factors that sparked the financial crisis in 2008 were the so-called Basel banking requirements, argues Stefano Micossi, and the EU should get its act together to heal these illnesses within the banking legislation.
Stefano Micossi is the director general of Assonime, a Rome think tank. He is also member of the Centre for European Policy Studies board of directors and teaches at the College of Europe.
"A new CEPS publication that will be released in the coming week argues that the Basel prudential rules for banking were one of the main culprits in generating the financial crisis of 2008-09 and in aggravating its real economic consequences. They permitted banks to accumulate total liabilities up to 40 and even 50 times their equity capital, owing to the fact that the calculation of capital requirements is largely based on banks’ own risk assessment.
High leverage multiplied the impact of falling equity on real economic activity, once confidence evaporated, as the banks were forced to sell assets and cut credit in order to replenish their capital. The stunning opacity of regulatory solvency ratios, which made weak banks look even better than strong banks, encouraged supervisors to turn a blind eye to excessive risk-taking by their regulated banks and stand on their side in the drive for international expansion.
The diversity in banks’ capital ratios also indicates a dramatic distortion of the international playing field, as increasingly competitive conditions in banking markets have come to depend on national discretion in the application of the banking rules. Meanwhile, market discipline was made futile by the opacity of capital indicators.
The new Basel III Accord has tightened the definition of capital and has modestly raised capital requirements, but has not eliminated the room for banks to manipulate capital ratio calculations, and for supervisors to connive with their regulated entities in delaying loss recognition and hiding the real situation. The problem of undercapitalisation, notably for core eurozone banks, has not been resolved, leaving our economies exposed to the risk of gigantic banking losses and a repetition of the dramatic fall in activity of 2008-09.
In its proposed changes to the Capital Requirements Directive (CRD IV) – which will transpose into EU law the Basel III Accord and is now under discussion before the European Parliament and Council – the Commission has weakened capital requirements even further and has broadened national discretion in the application of the rules.
While horse trading in the Council cannot be expected to correct these weaknesses in banking legislation, there is hope that the European Parliament may be willing to do it.
In our study we argue that:
- Capital requirements should be determined with simple reference to the total size of the balance sheet, with no adjustments for risk weighting by the banks;
- Supervisors should be made accountable to markets and the public at large by a system of mandated corrective action, as pioneered by the US Federal Deposit Insurance system;
- Market discipline should be strengthened by requiring the banks to issue substantial amounts of debt that are automatically convertible into equity, based on reliable market triggers, when their capital position weakens.
Only with these changes can we be confident that a repetition of the events of 2008-09 will be avoided.
Prudential rules are the foundation of financial stability. It is high time for elected representatives to take the issue back into their own hands and tackle it in the general interest of savers, investors and taxpayers."