21 April 2017

Vox EU: The Basel process of capital regulation: A story of good intentions and unintended consequences

In her foreword to the first Annual Report after taking over responsibility at the ECB for supervising European banks, Danielle Nouy states: “Over the course of 2015, we made good progress in promoting the objectives of European banking supervision. We contributed to the safety and soundness of credit institutions and to the stability of the financial system. We also promoted the unity and integrity of the internal market based on equal treatment of credit institutions” (ECB 2016).

After the twin crises of the new millennium, this sounds like wonderful news, especially for European banks, except that the goal of contributing to the safety and soundness of the financial system had already been the stated goal of the Basel Accord in its original version about 30 years earlier. The Accord, now commonly referred to as Basel I, states:

 “Two fundamental objectives lie at the heart of the Committee's work on regulatory convergence. These are, firstly, that the new framework should serve to strengthen the soundness and stability of the international banking system; and secondly that the framework should be in fair and have a high degree of consistency in its application to banks in different countries with a view to diminishing an existing source of competitive inequality among international banks” (Basle Committee on Banking Supervision 1988).

This raises the question of whether the Basel process of capital regulation might not have achieved its intended goals, and, hence, whether it has triggered the need to develop a new supervisory infrastructure such as the Banking Union in Europe. In a recent paper, authors provide an evidence-based policy evaluation of the Basel process of capital regulation (Gehrig and Iannino 2017). In a first step, they trace the trajectories of various commonly used systemic risk measures and document important non-linearities and heterogeneity across size groups. They find that the major build up in exposure to systemic risk remains concentrated in the upper quintile of banks, while for the majority of banks no such secular increase in exposure to systemic risk can be documented. In a second step, they identify the drivers of these unequal developments, which essentially are the options to self-regulate by the use of internal models for market risk and credit risk subject to supervisory approval.

Authors document a secular build-up of capital shortfall of the European banking industry. Ironically, and counter-intuitively, by trying to regulate minimal capital standards, the Basel process itself contributed to an ever-increasing shortfall in aggregate bank capital. Consequently, European banks have become increasingly exposed to systemic risk over the last three decades.

The main drivers of this process appear to be the self-regulatory options introduced into the Basel process with the amendment for market risk (1996) and culminating in the introduction of internal models for credit risk in Basel II (2006). Rather than providing incentives for better risk management for the larger and internationally active banks, precisely those sophisticated banks used internal models to carve out even more equity in order to increase return on equity and at the same time reduce resiliency. In light of these results, placing caps on the use of internal models seem reasonable policy options.

However, reverting the Basel process and replacing complex rules – such as Basel II, III, IV and so on – with simple rules such as the original Basel Accord (Basel I) may be an even more effective way of reducing lobbying powers and system manipulation. In this light, the suggestion of Admati and Hellwig (2013) to impose a simple floor on capitalisation are worthy of serious consideration. Moreover, the recent history of re-capitalisation of UBS demonstrates that systemic risk exposure can indeed be reduced to pre-crisis levels when it is done seriously enough.

Implicitly, their study unveils another unintended consequence of policy, namely that expansive monetary policy adversely affects the resiliency of banks. The negative effect of the policy rate on systemic risk exposure is very robust and holds across the whole spectrum of banks. This finding suggests that expansionary monetary policy is not a good instrument to aid recapitalising ailing banks.

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