12 December 2012

Thomas M Hoenig: Get Basel III right and avoid Basel IV

Each new Basel standard attempts to correct the errors and unintended consequences of earlier versions. But instead of resulting in better outcomes, each do-over has been more complicated and less effective than the last. Most disturbingly, each fails to provide enough real capital to absorb unexpected shocks to the economy.

Once again, in an effort to remedy the flaws of earlier versions, Basel III is meant to increase the quantity and quality of capital on the balance sheet. Some remain confident that Basel III accurately assigns risk weights to numerous categories of assets. Unfortunately, the weightings are more arcane than ever and, therefore, even less useful. Despite the promise of higher capital levels and better quality capital, Basel’s new minimum leverage ratio requirement is only 3 per cent, about the same as that of the largest US banks when the global crisis erupted. Basel III offers more complexity and, therefore, new opportunities to circumvent the system. But it does not offer any more certainty that banks will be well capitalised when the next crisis hits.

We can establish a simple but stronger capital base by replacing the unmanageably complex Basel risk-weighted standards with a tangible equity capital ratio of around 10 per cent, and use a simplified risk-weighted measure as a check against excessive off-balance sheet assets or other factors that might influence banks’ safety.

If the financial industry had had tangible equity capital approaching this level in 2008, we might still have had a crisis. But it would have been far less severe and far less costly to the public. Basel III’s implementation has been postponed, and that offers a real chance to get it right. If we do, we won’t need Basel IV.

© Financial Times