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A Radical Proposal On Basel III: Maybe We Should Just Ignore It

“World Panel Backs Banking Rules To Avert Crises.”

That’s the headline from the New York Times story on the so-called Basel III accords.

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Do you believe it? Do you believe that despite all our past failures to regulate the banking sector to avoid crises that this time it will be different, that this time we finally got it right?

Let’s back up. Yesterday we learned what top central bankers and bank regulators agreed in Basel about the future of bank capital requirements. (Felix Salmon has a good discussion of the details here.)

The next step will be ratification by the G-20 nations in November, followed by implementation by each participant’s national lawmaking and regulation writing apparatuses.

Crisis or Opportunity?
Ratification is all but a certainty. Implementation far less so. Bank lobbyists will attempt to pressure their home legislatures to make modifications to the plan agreed in Basel. And with the extended implementation period permitted by the agreement for some provisions, banks will have plenty of time and opportunity to argue for change.

Keep in mind that the last international banking accord—Basel II—was never fully implemented. There’s little reason to suspect Basel III has a better chance of implementation. Ask yourself: is the banking sector more or less influential than it was a decade ago?

See what we mean?

Far from being a crisis, however, the fact that Basel III might be undermined should be welcomed as an opportunity. The persistent failure of earlier international agreements to create a stable global financial system should be read as an indication that such agreements simply cannot perform as advertised. All Basel agreements will likely fail because they are built on regulatory overconfidence.

Overconfidence is a cognitive bias that has become well known in policy circles thanks to the work of behavioral economics types. It is the illusion that our personal abilities, including our knowledge, are better than they really are. People regularly over-estimate, for instance, their own scores on simple texts of factual knowledge. Abd investors often think they know more about markets and companies than they do.

The Dangerous Overconfidence Of Regulators
You don’t hear much about regulatory overconfidence because the kinds of people who are attracted to behavioral economics tend to instinctively support regulation. (Someday soon we’ll have to do an entire series of posts talking about this cognitive bias.) Regulatory overconfidence is not really anything that complex or surprising: it is just the cognitive bias of overconfidence that emerges among regulators and bureaucracies.

The sources of the bias are easy to understand. People attracted to jobs in financial regulatory bureaucracies are likely to believe that financial regulations are necessary and effective. This initial attraction is organizationally reinforced as the bureaucracies reward those who maintain the belief and punish—or fire—defectors. Selective perception and retention of information seem to confirm the initial belief, resulting in the creation of a kind of fortress of regulatory conviction.

To put it simply: of course regulators believe in regulation.That’s what they do.

The form overconfidence takes among regulators tend to be the assumption that the important consequences of regulatory actions can be known to regulators. The notion that regulators might be mistaken, or that different regulations might interact with each other in unexpected ways, or that unanticipated future events may undermine even well-wrought regulations is largely absent from the discussions of regulators.

Of course, regulators try to anticipate unintended consequences. But they are closed to the proposition that the complexity of the global banking system combined with the complexity of the global regulatory system may make such attempts at anticipation impossible.

If you have any doubt about the level of over-confidence regulators have, look back at that New York Times headline quoted at the start of this piece.

“World Panel Backs Banking Rules To Avert Crises.”
It’s not just a matter of whether they’ve adopted the correct rules. It’s a matter of whether such rules even exist. What reason do we have to believe that any set of rules adopted by a world panel will avert banking crises?

Let’s take, for example, the recent financial crisis. As the political scientist Jeffrey Friedman has demonstrated, regulators failed to understand that reliance on credit rating agencies was ill-advised, in part because they did not understand how other regulations granting oligopoly status to the agencies had undermine their efficacy.

Furthermore, they did not appreciate that encouraging reliance on credit ratings agencies would render sophisticated financial enterprises so vulnerable.

Lehman's Capital Far Exceeded Basel RequirementsAnother example. Lehman Brothers had Tier 1 capital far in excess of that required by Basel II. In fact, it had Tier 1 capital that far exceeds the new requirements. That didn’t save Lehman. Similarly, almost every commercial bank in the United States had capital that met or exceeded the Basel II requirements. But following Lehman’s failure, they all feared that many of their counterparty commercial banks could be insolvent because they were loaded down with mortgage backed securities that had lost so much value. This led to the credit crunch despite the fact that the banks were compliant with the existing regulatory requirements.

We now know all this—but we know it in hindsight. Lots of people understood parts of it prior to the crisis. But the way the pieces fit together became apparent only during and afterwards.

And that’s the point. Modern finance—including the private institutions and the regulatory and political superstructure built around them—is a complexity whose surface patterns are recognizable but is far more complicated than generally appreciated. We mistakenly believe that we understand it.

Complexity and Regulation
The fact that experts at Basel who believe they understand global banking well enough to regulate it disagreed until sometime Sunday suggests a high level of complexity. Even today, well-meaning and knowledgeable experts will disagree about whether the Basel group reached the right agreement. Some of these folks will turn out to be right and others will be wrong.

The problem, however, is that the decisions of one set of experts is embodied in the banking rules. Or, perhaps more accurately, the views of a diverse set of experts have been subject to a political compromise that embodies none of their views about prudent banking.

And that compromise is intended to have the strength of law across the entire planet, ignoring the complexity and unpredictability that undermined earlier attempts to stabilize the banking system. There isn’t supposed to be any local testing with different rules, any deviation based on the diversity of opinion that we know for a fact actually exists. Rules is rules.

The scary thing is that we simply cannot know if the compromise reached in Basel correctly anticipates the future and doesn’t have malevolent interactions with other regulations, including novel (and therefore untested) restrictions on short selling, derivatives trading, proprietary trading, and consumer finance. Maybe we got it right this time. Or maybe that’s our overconfidence fooling us again.

Anyone wanna bet which one it is?

Given this uncertainty, the fact that Basel III will take years to implement and may be undermined by local banking interests along the way should probably be considered welcome facts. Maybe this time we’ll discover our mistakes before it is too late. Or maybe the best thing to do is just ignore Basel III from the get go.

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