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Home > Regulation Best Practice > Tripping over Prudence—Ideas for a Sensible Fix for Basel II

Regulation Best Practice

Tripping over Prudence—Ideas for a Sensible Fix for Basel II

by Samuel Sender and Noel Amenc

Executive Summary

  • Why the combination of government bail-out money and retained capital ratios is flawed

  • The feedback loop involved in marked-to-market amplifies book risk in a downturn and distorts management and regulatory responses

  • The importance of creating a buffer

  • Floor and target capital levels generate substantial advantages in providing banks with more flexibility in a crisis

  • Off-balance sheet disclosures will be addressed by the new regulatory requirements as part of the risks on which banks will have to manage and report.


One of the great ironies of the present crisis, given the prevailing consensus that it was too much easy, low-cost credit that caused the US housing bubble, and sent investors off in search of higher returns, is the way the crisis has been exacerbated by undue regulatory prudence. For this, Basel II, as it currently stands, must take some of the blame, as must regulators around the world, who have failed so far to take sensible action to mitigate the effects of Basel II.

Certainly, governments around the world have been taking action, often fairly dramatic action, to pump money into the banking system, and this might look anything but prudent when considered from the standpoint of the long-term debt that countries are generating for future generations. Yet the iron hand of prudence remains, in that there has, at the time of writing (mid-March 2009), as yet been no relaxing of bank capital ratios.

An Unhappy Combination

This combination of government bail-out money and retained capital ratios does not stand up well to analysis. It is only necessary to grasp the scale of total assets in the global banking system for the point to emerge. Total bank assets are as great as the combined total of the stock-market capitalization of all the world’s exchanges added to total public-debt securities. This is more than twice the size of total global pension-fund assets, and more than 40% larger than world GDP. It follows that 8–10% of this total is a very big number indeed, which is what the Basel II capital-adequacy ratios demand banks retain as, basically, unusable capital in their capital reserves.

One of the issues here is that Basel II mandates that banks raise capital or cut lending as their risks are perceived to increase. That this is pro-cyclical is a point that has been made many times. It constrains banks precisely when a cure for the global predicament is for them to lend (reasonably prudently) to corporates, municipalities, and housing markets.

When bank assets suffer large depreciations, and suppliers of capital are not present in the market, the lack of the ability of banks to restore capital ratios means that their desire to cut lending halts the economy. For this reason, regulators need to allow banks to have temporarily lower capital ratios during downturns. In the present case, it took more than six months, after the Lehman bankruptcy, for the Basel Committee simply to admit that they were prepared to take action to alleviate the pro-cyclical nature of Basel II, and to state it would not advocate raising capital requirements during this period of economic stress. Whereas, an immediate reaction was needed, at least from national regulators, given the lack of a global supervisor at that time. National regulators and supervisors had the chance to define more precisely the buffers expected under Pillar II, without formally departing from the Basel accord, because buffers above the 4% minimum Tier I requirement are only defined in a qualitative manner in the Basel accord.

During the recent downturn, Basel II has, instead of easing the banking situation and freeing up capital to support lending, forced yet more funds to be locked up in capital reserves, thus deepening the downward cycle (the meaning, of course, of being pro-cyclical).

The point has also been made many times that marked-to-market accounting rules, as introduced by the International Financial Reporting Standards, exacerbate the impact of Basel II on bank capital ratios, by amplifying notional book risk, which raises the capital ratio and further constrains liquidity, in a vicious feedback loop. The direct result is the appearance of systemic risk in the global banking sector, which only governments appear to have the necessary “deep pockets” to resolve—hence the general decision by national governments to pour money into the system. Because of delays in government decisions, this also involves the risk of inefficient public intervention: while governments were fixing the bank capital ratios, the economy was experiencing a large downturn; now that they are trying to support the economy, rising default rates mean bank capital ratios are hit for the second time.

This policy also runs some very severe fiscal risks. It may well weaken both the banking system and public finances. The Financial Times, for example, recently likened the government’s underwriting of UK bank debts to the predicament of a python engaged in trying to swallow a hippopotamus. In this analogy, an investor might feel uneasy betting their house on the snake’s digestive capacity, and, in fact, the markets have rendered their judgment in the downward spiral of both bank share prices and ratings for sovereign debt (including sovereign CDS spreads).

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