Why New Bank Capital Rules Could Make Things Worse

Investors will likely breathe a sigh of relief when international regulators reach an agreement on bank capital requirements this weekend.

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Early reports suggest the required levels of capital will be much lower than feared, and the kinds of assets that can be used to meet the requirements more expansive than earlier proposals suggested.

But there is good reason to worry that far from making the financial system sounder, Basel III may introduce even more systemic risk into global finance.

The problem is inherent and probably unavoidable. Regulators want to achieve a world-wide harmony on bank capital rules. But by reducing the diversity of regulatory regimes, they inevitably increase the costs of regulatory error.

Regulations homogenize. Banks told that certain assets count as regulatory capital will hold more of those assets than they otherwise would. If those assets are less safe than the regulators believe, banks will be more vulnerable and the banking system more fragile than it would be with less homogeneity.

As Jeffrey Friedman has pointed out, it was prior capital requirements that encouraged banks to hold large inventories of mortgaged-backed securities. The financial crisis was a result of what happened when the bursting of the housing bubble met this regulatory-created concentration.

"Bank-capital regulations inadvertently made the banking system more vulnerable to the regulators' errors," Friedman explains. "But this is what all regulations do."

We’re sure the regulators in Basel are well-meaning and striving to implement prudent and informed rules. The problem is that the future is unpredictable. What’s more, any set of regulations that seeks to cover something as complex as the global banking system inevitably will have unintended consequences. Further, even well-wrought regulations cannot easily adapt to changing circumstances.

Markets can cope with uncertainty because they do not require homogeneity. Different companies make different predictions about which businesses will be profitable. The ones that get their predictions wrong lose money; the ones that get them right earn profits. Persistent or outsized predictive failures led to bankruptcy; while persistent or outsized predictive successes leads to growth or at least continued operations. The market process sorts winners from losers without anyone having to determine who made the right predictions.

Regulations lack this discipline. Where a business can see its inventory build or profits fall and change directions, regulatory failures are often invisible until very late in the process. The failure of prior capital rules did not put the regulators out of business. In fact, this round of Basel negotiations has even more countries participating than the earlier round did. Throughout the financial crisis and afterwards, regulators have failed upward. Evaluations of which regulations failed is open to political debate rather than being self-evident.

The rules coming out of Basel will inevitably encourage concentrations of risk management strategies and asset holdings that will make the financial system more fragile. The more detailed the rules are, the more systemic risk-creating homogeneity will be introduced.

All of which is not to say that we don’t need banking capital regulations. For a host reasons—not the least of which is that banks have demonstrated that they can shift losses onto taxpayers—we do. But we shouldn’t be too confident in the efficacy of our new regulations, no matter how swell they might seem to us now.