Never mind the buffers: Covid reveals deeper flaws in Basel III

For much of the past decade, debates over financial regulation have followed a familiar pattern: regulators propose new rules; banks warn they are going too far; regulators respond that the rules are necessary to prevent a repeat of the 2008 financial crisis. 

This year, the roles have been reversed. Regulators worry stringent capital requirements may be discouraging banks from lending to a Covid-afflicted economy. Banks say they must be careful to avoid a repeat of the 2008 financial crisis.

Nowhere is that more evident than in banks’ reluctance to run down their capital buffers. Regulators temporarily relaxed these requirements at the outset of the pandemic to encourage banks to keep lending through the impending economic crisis. But the anticipated wave of lending never materialised, and capital ratios have barely budged since the start of year.

Banks say this reflects tepid demand for loans. And their caution may well be validated if losses start to mount and capital buffers start being eroded next year, when government support packages and loan moratoriums are due to expire.

Regulators seem reassured. Carolyn Rogers, secretary-general of the Basel Committee on Banking Supervision, said in October that she had yet to see “concrete evidence” that excessively stringent capital requirements were holding back the supply of credit to the economy.

Perhaps this is why senior members of the committee were confident telling G20 finance ministers in November that “any further potential adjustments to Basel III will be limited in nature”.

To some extent, this may be because the changes necessary to encourage banks to run down their capital buffers in times of economic stress do not contradict the existing Basel standards. For instance, the Bank of England has already begun re-examining the capital threshold triggers for suspending equity dividend and alternative tier 1 coupon distributions. Basel is not prescriptive on the exact mechanisms by which regulators force banks to preserve capital when their ratios are sliding, so there is plenty of room for rule changes without the hard work of seeking a global consensus.

But it is also possible that the pandemic has raised some issues that regulators are less willing to talk about, for fear of reopening much more controversial and time-consuming discussions around Basel III.

One such concern is that internal models based on recent historic loss rates are inherently procyclical, causing bank capital requirements to jump at precisely the moment when the losses themselves are eating into capital.

Another is that the leverage ratio’s failure to distinguish ultra-low-risk assets such as government bonds and government bond repo – which are also vital for liquidity in the financial system – amplifies market shocks. This is why there are calls for the temporary exclusion of Treasuries from the US leverage ratio to be made permanent.

Regulators are understandably anxious about providing banks with a new opportunity to lobby for deregulation. However, this debate could also go in a direction that would be unwelcome for banks.

One way to ensure they have countercyclical balance sheet capacity to cope with market and economic shocks – which has already been mentioned in a submission to the European Parliament – is to impose heavier requirements in the good times, so that more capital is available for release when things turn bad.

Perhaps the problem is not that capital buffers were too high in the bad times, but that they are not high enough in the good times.