Even as governments in individual countries are struggling to move forward on post-crisis financial reform aimed at preventing another crisis, the G20 seems to be settling for marginal modifications of the pre-existing framework for global regulation– at the centre of which are the Basel norms. The Basel norms in their various versions essentially require banks to hold capital amounting to a certain proportion of their risky assets in forms that are available and easily accessed to cover losses. Capital that was free of encumbrances and liquid to different degrees was ranked Tier I or Tier II, with each Tier required to be kept at a certain proportion of the value of risk-weighted assets.
This kind of structure was seen as constraining banks by making risky investment costly. If a large volume of risky assets that promise higher returns was held by a bank, its aggregate return would be limited by the fact that it would have to set aside more capital for adequacy purposes in investments with low return. It was by disincentivising risky behaviour in this fashion that the Basel framework expected to prevent financial failure.
Once the emphasis was on capital adequacy, a struggle over three kinds of issues ensued. The first was on defining the kind of the capital which can be considered appropriate for adequacy purposes. Second, was a struggle over who was to determine risk-weights and how they were to be assigned. Finally, there was the controversial issue of how high the capital adequacy norm should be set.
What the 2007-08 crisis demonstrated was that “softer” or “weaker” forms of capital could turn completely illiquid, lose value, and/or disappear. Further, it made clear that the private rating agencies had completely underestimated the riskiness of most assets. Finally, 8 per cent of capital relative to risk-weighted assets had proved woefully inadequate to cover the losses incurred.
This gave cause to argue that it was necessary to move away from a regulatory framework that put capital adequacy norms at the centre. Afraid that this may result in a return to structural regulation of the Glass-Steagall kind, the banking industry has been lobbying against any such shift. This it did by getting the Basel Committee on Banking Supervision (BCBS) to declare its intention to significantly strengthen capital standards and raise adequacy requirements and to get G20 governments to declare Basel-type norms as the principal means of global financial regulation.
In proposals drafted as early as December last year, BCBS had recommended a substantial increase in capital adequacy ratios. Besides, those proposals argued for elimination of certain kinds of capital such as subordinated debt, shares in subsidiaries, mortgage-backed bonds and deferred tax assets from the definition of regulatory capital. Finally, either higher risk ratings or larger capital requirements were demanded for assets such as over-the-counter derivatives.
The proposals did not stop there, but added three kinds of requirements to ensure safety. The first was adherence to a specified “leverage ratio” or the ratio of regulatory capital to total assets valued without any risk weights. The second was adherence to liquidity requirements needed to deal with severe stress. And finally, adherence to a “net stable funding ratio” defined as the ratio of liquid assets to the value of liabilities maturing in one year or less, which would ensure that banks have more liquid assets and relied on longer-term funds.
Confronted with these options, the banking lobby got to work and declared that these guidelines would raise the cost of capital and affect growth adversely. Agreement on the new norms proved difficult to realise making a November deadline for such an agreement set by G20 governments a source of much pressure. Succumbing to such pressure, the BCBS seems to have substantially diluted its original proposals. In the proposals that would now go to the G20 summit in Seoul this November, banks are allowed to include in Tier I capital mortgage servicing rights, deferred tax assets and equity held in subsidiary institutions. The leverage ratio has been set at an unexpectedly low 3 per cent, which needs to be realised only by 2018. The norms for liquidity requirements have been substantially relaxed. The decision on the net stable funding ratio has been postponed. And the decision on how high the capital adequacy ratio should be set has been deferred allowing for haggling that is likely to make the increase small.
Clearly the banking giants have once again been able to stall even limited regulatory reform by invoking the bogey of an aborted recovery if rules were tightened adequately.