After you read this, you will care about Basel III

The JP Morgan Chase building on Park Avenue.

The Federal Reserve today approved final rules under the Basel III international banking agreement, increasing capital requirements for all U.S. banks. The regulations come into effect over several years.

The goal of the regulations is to reduce systemic risk to the financial system -- and especially to the largest banks, sometimes called 'systemically important' or ‘too big to fail’ -- by bolstering the amount of shareholder equity banks must maintain. Banks will need to maintain a total capital ratio of 8 percent of risk-weighted assets.

“Sooner or later something will go wrong,” says Karen Shaw Petrou, managing partner Federal Financial Analytics. “And they’ll go less wrong if shareholders have more at risk. Shareholders will be less likely to look the other way” if bank executives and employees take big risks that go bad. “If banks fail, the deeper cushion of shareholder equity up front reduces the cost of the failure to the FDIC or to other regulators.”

Petrou says Basel III’s capital requirements should mitigate, at least somewhat, the kinds of risks faced by the banking system, and ultimately the entire economy, during the 2007-2008 financial crisis.

“Banks had thin capital cushions,” says Petrou. “And when markets went upside down, they blew up. They couldn’t even sustain overnight stress, because they had no resources to hang on.”

The heightened capital buffers required under Basel III are designed, she says, “to give the banks the resources to weather a storm when the next crisis hits. Shareholders don’t get to keep the profits without taking the risk.” She says tighter underwriting standards, better bank supervision, more significant loan-loss reserves -- some of which is required under the Dodd-Frank financial reforms passed by Congress -- will also reduce systemic risk.

Small and mid-sized banks will face the same overall capital requirements at the eight biggest banks -- Goldman Sachs, Bank of America, J.P. Morgan Chase, Citigroup, State Street, Bank of New York Mellon, Wells Fargo, and Morgan Stanley. However, the smaller banks will be able to count some of their holdings differently in determining if they meet the capital requirements.

But if the goal is to reduce risky financial dealings by banks, economist Ted Truman says Basel III might not work exactly as intended. Truman was head of international banking regulation at the Federal Reserve from 1977 to 1998; he is currently a senior fellow at the Peterson Institute for International Economics.

“I actually don’t think that banks are going to take less risk,” says Truman. “They’re going to have more capital to absorb that risk, so when they make mistakes it’ll impact their capital rather than force them into bankruptcy.”

Truman says the goal of Basel III and Dodd-Frank is to ‘take some of the risk out of banking, because if banks take on too much risk, they fail, and that affects the economy as well.”

But Tom Deutsch, executive director of the American Securitization Forum, says too much banking regulation, or overlapping, conflicting regulations (for instance, under Dodd-Frank and Basel III), could end up slowing the economy, by slowing lending. Deutsch’s organization represents lenders, borrowers, and investors in securities backed by assets such as mortgages, car loans and student loans.

“Applying new capital rules will certainly improve the prospect that there will be less bank failures on a go-forward basis,” says Deutsch. “The downside of that is that by requiring banks to effectively maintain a significant amount of additional capital, the likelihood of less lending on a go-forward basis is very high.”

And, says Deutsch, “to try to eliminate risk in banking is to effectively say that no loan should be made, because inherently in a loan, there is some kind of risk.”

And as we’ve seen since the financial crisis, bankers still like to take plenty of risks. It’s possible no amount of capital held in reserve will be enough to keep banks standing in the next financial storm. Or, to protect taxpayers from the bank collapses that would follow.

“The really critical challenge here is balancing the need to raise the capital requirements, to make banks stronger, with the vital importance of not destroying the incentive, the basic function of banks to make loans,” says Petrou. “If you tried dollar-for-dollar capital requirements for banking, you might have nominally very strong banks. But they’d never make any of us a loan ever again.”

About the author

Mitchell Hartman is the senior reporter for Marketplace’s Entrepreneurship Desk and also covers employment.

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