Basel rules risk punishing the wrong banks

Posted on Wednesday, October 27, 2010

By Jacques de Larosière
Published: October 25 2010 22:38 | Last updated: October 26 2010 15:32
Financial Times
Politicians are determined to strengthen the financial system in order to avoid a repeat of the current crisis, which has resulted in such enormous costs in terms of growth, employment and public budgets. They can only be satisfied by a steep increase in capital requirements, most obviously as proposed by the Basel Committee on Banking Supervision. The Basel recommendations would at least quintuple the amount of core capital to be held by banks, requirements that will no doubt be increased again in the coming weeks.
But such “re-regulation” can have unintended consequences. It could encourage a transfer of heavily taxed operations in terms of capital requirements, such as trading, to the so-called shadow banking system, outside the scope of regulation and supervision. Such shifts may endanger financial stability unless current re-regulation is accompanied by new regulatory and supervisory structures for “non-banks”. Efforts in this respect are under way but they are still at the project stage, and will take time.
The second big cause for concern touches specifically on European banks and their business model. The new Basel capital and liquidity rules would, in the medium term, lead to reduced profits and increased competition regarding the generation of deposits. This inevitable rise in costs would have to be offset by higher productivity and, no doubt, higher costs for banks’ clients. Under pressure from extended competition, certain banks will be encouraged to operate in a way that is more profitable but at the same time more risky.
Analysis of the crisis shows that the two main banking systems reacted differently. The Anglo-Saxon “originate and distribute” model developed considerable trading activities and (mostly non-supervised) off-balance sheet vehicles with profitable but risky and opaque products. Banks with this model were heavily hit by the subprime crisis, leading to massive state and central bank interventions designed to avoid contagion.
By contrast, continental Europe’s universal banks were more diversified, with retail and corporate lending operations, fund management and other activities mainly concentrated on a client base. Such lenders were preoccupied by the ability of borrowers to repay, rather than by the value of the assets to be financed; their strong deposit bases conferred stability on the system as a whole. This second model almost survived without public bail-outs. European banks that did require assistance had mostly adopted the aforementioned riskier “investment bank” practices or had imprudently bought toxic products.
The risk of the new rules is that these stable institutions, required to increase their return on investment, would reduce activities with modest margins such as lending to small and medium-sized enterprises. Alternatively credit costs would rise or banks would concentrate on the more profitable (and riskier) parts of their portfolios. This would have major detrimental effects on the real economy and on the soundness of the financial system.
The cruel irony is that the banking model that most favours financial stability and economic growth could be the chief victim of the new framework. The model that caused the crisis would, at least in part, be left in place. We would see an enforced search for a maximum return on assets – one of the biggest problems in the years before the crisis, when immediate profitability was too often deemed more important than sound analysis and risk prevention.
The proposal to introduce an absolute leverage ratio without taking into account the real risk of assets is the most contestable element of the Basel reforms, and would push banks to concentrate their assets in riskier operations. This is also the case with plans regarding an additional ratio for so-called “systemic” banks – that is to say the largest banks, which are unpopular in the US but which play a fundamental role in Europe and have demonstrated their solidity. Overall it is the European economy, which takes three-quarters of its financing from banks against only a quarter in the US, that would suffer most.
More generally speaking, we need to take into account that effective regulation requires competent and efficient on-the-ground supervision. Rather than aligning European banks to the drawbacks of the Anglo-Saxon model, we should seek inspiration from those systems of supervision that worked best during the crisis.

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