Off Balance

by Paul Blustein

  To address one obvious hole in this process — the possibility that a country could, single-handedly, veto approval of its own review or some other review that it didn’t like — a recently published FSB handbook on peer reviews makes it clear that this shouldn’t be countenanced: “Plenary decisions are taken by consensus. Consensus is not synonymous with unanimity. Rather, for the purpose of peer reviews, consensus is understood to mean that the views of all members are considered and compromises are sought, but that no single jurisdiction can block a decision supported by a clear majority.”19

  19 FSB (2011), Handbook for FSB Peer Reviews, December, available at: www.financialstabilityboard.org/publications/r_120201.pdf.

  Well-conceived, commendable...but is all this transformative? These innovations render the FSB different from the FSF in substantial and beneficial ways. Are the differences enough?

  Remember that the FSF also had a process for assessing and prioritizing risks — the High-level Vulnerabilities Working Group — and it, too, commenced with an exhortation to take macro-prudential issues into greater consideration. Expectations for the FSB’s new risk-spotting approach should be dampened accordingly.

  Furthermore, the FSB is still a network, grounded in soft law rather than a formal institutional arrangement such as a treaty. Although its Secretariat may be bigger (about 25 staffers, at last count) than the FSF’s was, it is still modest, and more than two-thirds of the staffers are on secondment from member governments and other international institutions. Without a much more independent identity, and the ability to hire a larger staff of its own, the FSB’s prospects do not appear bright for the kind of ruthless truth telling that might command attention from national authorities. As a result, peer reviews are unlikely to be free from the aforementioned “great defensiveness and excessive politeness.” (Evidence from peer reviews to date tends to support this skeptical perspective.) Members know that harsh treatment toward others will invite the same on themselves. For much the same reason that it is hard to conceive G20 leaders joining together to shame one of their members into changing macroeconomic or currency policy, it is hard to conceive of the FSB engaging in the loud whistle-blowing and unpalatable message sending referred to earlier as hallmarks of effective surveillance.

  Even a superb chairman like Carney cannot compensate for the constitutional debilities of the body he or she heads. Perhaps, though, the FSB’s debilities don’t matter as much as other international regulatory concerns. After all, didn’t Tim Geithner spout the mantra of “capital, capital, capital” as the most critical factor in making the system less crisis-prone? Indeed he did. And wasn’t there some merit in what he said? Indeed there was. And don’t the new Basel rules require banks to maintain significantly more capital than before? Indeed they do. And are the amounts anywhere near sufficiently high? There’s the rub.

  616 Pages!

  “Watching fresh paint dry” is how Sheila Bair, in her memoir Bull by the Horns, describes meetings of the Basel Committee and the associated meetings of agency heads overseeing its deliberations that she attended during her 2005–2010 tenure chairing the US Federal Deposit Insurance Corporation. Like most other international economic institutions, the Basel Committee operates by consensus, which means that the speakers dominating the discussion tend to be those resisting whatever change is under consideration. “Reform opponents would typically filibuster — that is, talk endlessly to wear other members down — and the best at this, by far, were the Germans,” Bair writes, citing Franz-Christoph Zeitler, an official at the German central bank, and Jochen Sanio, the top banking regulator. “Franz and Jochen could drone on for hours, and if we tried to accommodate them with some kind of compromise, they would raise the ante and drone on some more.”20

  20 Sheila Bair (2012), Bull by the Horns: Fighting to Save Main Street from Wall Street and Wall Street from Itself, chapter 22, NewYork: Free Press.

  Unkind and unfair, no doubt; but that account helps to explain the outcome of Basel III. Although the Basel Committee was under tremendous pressure after the crisis to reach a deal in record time, its members represent sovereign governments, who cannot be forced to accept rules they don’t like. More so than in bodies that make decisions by majority vote, compromises must, therefore, be “least common denominator” in nature, and the Basel Committee ended up with an agreement substantially less ambitious than it should have been.

  Ensuring that banks maintain an abundance of capital was important prior to the crisis, but became an even more compelling imperative afterward, in part because of the reason cited by Geithner: “We don’t know where the next crisis is going to come from. We won’t be able to foresee it,” he told The New York Times in March 2010. “So we want to build a much bigger cushion into the system against those basic human limitations. I don’t want a system that depends on clairvoyance or bravery.”21

  21 David Leonhardt (2010), “Heading Off the Next Financial Crisis,” The New York Times, March 25.

  Moreover, the financial system’s woes were attributable, in large part, to the banks’ penchant for leverage, that is, funding themselves heavily with borrowed money atop thin capital bases. Doing so had enabled them to reap hefty returns on capital (which had, in turn, boosted stock prices and bonuses) — until the profits turned to losses, depleting the banks’ capital at such alarming rates that confidence in their solvency was undermined. When governments were forced to rescue the biggest banks to prevent the whole system from collapse, the heads-the-banks-win, tails-everyone-else-loses nature of the arrangement became glaringly apparent. If the banks had been much better capitalized, most of the ones that landed in trouble could have skated through without bailouts; only their stockholders would have suffered, while taxpayers, depositors and the rest of the financial system would have been protected.

  So Basel III had to improve on Basel II — and by that metric it succeeded, even in the view of its harshest critics (although it has long phase-in periods, with a target date of 2019 for going fully into force). For the highest-quality capital — that is, absent accounting gimmicks that banks were allowed to count as capital under previous Basel accords — the new rules set a minimum of 4.5 percent of risk-adjusted assets, more than double the Basel II ratio, plus an additional “buffer” of 2.5 percent, for a total of seven percent. On top of that is another new buffer of between one percent and 2.5 percent for banks with the G-SIFI designation.

  The simplest way to demonstrate the inadequacy of those figures is to compare them with data published by the IMF in 2010 showing the losses that banks in major financial centres suffered during the crisis — seven percent of assets for US banks and 5.4 percent of assets for UK banks.22 It will be very difficult for a bank to survive a crisis that erodes its capital ratio down to just a couple of percentage points; the IMF’s data imply the necessity for banks to maintain cushions well into the mid-teens.

  22 The figures come from IMF (2010), Global Financial Stability Report, April, and are cited in greater detail in Morris Goldstein (2011), “Integrating Reform of Financial Regulation with Reform of the International Monetary System,” Peterson Institute for International Economics, Working Paper WP 11-5, February.

  That is just the start of the major flaws in Basel III, whose most damning indictment came from one of the Basel Committee’s own members in a memorable August 2012 speech titled “The Dog and the Frisbee.” The speaker, Andy Haldane, the Bank of England’s executive director for financial stability, essentially accused his fellow Basel Committee members of having engaged in an exercise in futility by trying to keep pace with modern global finance. Pointing out that the documents comprising Basel III totalled 616 pages, compared with 347 for Basel II and just 30 for Basel I, Haldane argued: “As you do not fight fire with fire, you do not fight complexity with complexity.” Simple rules have proven superior to complex ones in other fields, he noted (Frisbee-catching, where dogs’ proficiency often exceeds that of humans, being one example). And that should be e
qually true in bank regulation, where the main source of complexity involves the increasing level of granularity with which banks have to weigh the risks of different assets. Whereas in Basel I assets were divided into five categories with different risk weights ranging from zero (for cash and short-term government securities) to 100 percent (for loans and residential mortgages on rental property), in Basel III the proliferation of weightings and estimates for individual exposures “has meant a rise in the number of calculations required from single figures a generation ago to several million today,” Haldane said. So what happens when all those calculations are dispensed with? Amazingly, substituting a much simpler and straightforward “leverage ratio” — that is, capital as a percentage of all assets, without regard to risk weightings — turns out to be a better predictor of banks’ vulnerability, Haldane showed.23

  23 Andrew Haldane (2012), “The Dog and the Frisbee,” paper delivered at the Federal Reserve Bank symposium in Jackson Hole, Wyoming, August 31, available at: www.bankofengland.co.uk/publications/Pages/speeches/2012/596.aspx.

  In fact, Basel III includes the first internationally agreed leverage ratio — one of its most sensible innovations — requiring banks to maintain capital equal to at least three percent of their total assets.24 But this ratio is relegated to a sort of “backstop” role, with priority going to the more traditional Basel-type risk-weighted measure. Far better, as Haldane asserts, would be to have both, and on roughly equal footing. Such a belt-and-braces approach is desirable because a leverage ratio alone would give banks greater incentive to load up their balance sheets with the riskiest assets possible.

  24 As noted in chapter 3, the United States imposed a leverage ratio prior to the crisis. Canada did as well.

  The biggest problem of all lies with the paltriness of that three percent figure. In their widely acclaimed book The Bankers’ New Clothes, Anat Admati and Martin Hellwig make the case for a leverage ratio in the 20 to 30 percent range — much more suitable, in their view, both to keep the financial system truly sound and to eliminate the pernicious subsidy that banks enjoy by borrowing.25 Even if Admati and Hellwig’s proposal is excessive, the three percent ratio used in Basel III draws nearly unanimous ridicule from experts outside the banking industry. Why, then, did the Basel Committee settle on such a low number? In part, it is because major international banks raised a clamour, asserting that if compelled to abide by stricter capital requirements they would incur massive costs, resulting in a reduction in lending that would sink the fragile global economy. Their claims were largely nonsensical and self-serving; for most big banks, capital is an “expensive” source of funding only because the alternative of borrowing is artificially cheap thanks to the prospect of government bailouts. But in some countries, regulators are anxious to protect their weakest banks, which lack the profits to build up capital or the ability to raise much money in the stock market. Whatever their motives, the Basel Committee members from France, Germany and Japan were the ones who most adamantly resisted efforts for higher capital requirements.

  25 Anat Admati and Martin Hellwig (2013), The Bankers’ New Clothes: What’s Wrong with Banking and What to Do about It, Princeton: Princeton University Press.

  Since safety barriers to prevent global mega-banks from failing are not high enough, it is all the more important that systems be in place to deal with such disasters when they occur. Progress in this area, however, also falls well short of being fully reassuring.

  Small Wonder: Financial De-Globalization

  This slow progress has not been for lack of brain wracking. Studies have been conducted, conferences convened, papers written and proposals issued. A comprehensive solution to the problem that John Gieve tried to get the FSF to tackle — how to manage, across many national borders and legal jurisdictions, the failure of a large and complex financial institution — remains elusive. As a result, “too big to fail” will continue to vex policy makers, notwithstanding their repeated vows of “never again.” And there is greater risk that in a future crisis, governments will act in uncoordinated fashion to protect their national interests, for example, by seizing assets that might be needed elsewhere in the world to keep a mega-bank afloat, all of which may exacerbate the financial system’s woes.

  The extra buffers of capital that the biggest and most interconnected G-SIFIs must maintain will help, somewhat, with the too-big-to-fail problem, as will discussions and planning among the colleges of supervisors that have been established for many such institutions. Perhaps, notwithstanding the skepticism of many experts, even the “living wills” — detailed plans that financial institutions must draft for how to wind-down their operations — will prove workable in a severe crisis. Still, the central, seemingly insuperable obstacles remain: first, the depth of the institutions’ complexity, and second, the unwillingness of governments to share ultimate responsibility at the international level for intervening troubled banks. As much as governments dislike using taxpayer funds for any bank bailout, they are especially averse to doing so for foreign banks. The creation of a supranational authority with the power and resources to manage the intervention of a mega-bank is, thus, illusory for the foreseeable future.

  This is, at bottom, the same problem that, during the mid-1970s, led policy makers from advanced economies to their first major agreement in global financial regulation, dividing responsibility among home and host regulators. As noted in chapter 2, countries hosting the overseas operations of foreign banks do not want the obligation of committing public funds for rescues of such banks, so home-country authorities were accorded primary responsibility for supervision.

  More broadly at issue here is the theme this book seeks to elucidate — the incongruities that arise in a world of globalized capital and sovereign nation-states, and the resulting frailties of the international institutions responsible for managing the system. Given those incongruities and frailties, it should not be surprising that the idea of turning away from financial globalization is gaining appeal. Indeed, in a number of countries, governments have taken steps that slow or even reverse the 40-year trend toward greater freedom in the movement of capital around the world.

  Emerging powers, including Brazil, Indonesia, South Korea, Taiwan and the Philippines, have imposed controls that limit inflows of capital; Iceland and Cyprus have restricted outflows. More importantly, governments in major financial centres are adjusting their regulations in a significantly less receptive direction toward foreign financial institutions. Britain has pressured foreign banks operating in London to establish subsidiaries that have their own capital and liquidity, rather than mere branches whose resources can be withdrawn at the whim of the home office. The United States is moving in a similar direction.26

  26 The US shift was heralded by a November 2012 speech by Daniel Tarullo, the Federal Reserve governor for regulatory affairs, whose words stirred consternation in financial industry circles. “I by no means want to imply that the United States should revoke its welcome to foreign banks,” Tarullo said. But citing the Iceland and Lehman Brothers episodes as instructive examples of how “capital and liquidity...were trapped” during the crisis, he said policy should reflect the reality that when the chips are down and creditors panic about repayment, countries will engage in “ring-fencing” — that is, preventing troubled foreign financial institutions from moving money out. And he noted that Switzerland, a classic case of a country with an outsized financial sector, has indicated that it may be obliged to let its banks’ overseas operations fend for themselves in a crisis. Accordingly, he said, for foreign banks operating on US soil, Washington would soon tighten regulations and require the maintenance of capital and liquidity buffers. See Daniel Tarullo (2012), “Regulation of Foreign Banking Operations,” speech given at the Yale School of Management Leaders Forum, New Haven, CT, November 28.

  These developments hardly imply an impending reversion to the balkanized world of finance that prevailed in the decades immediately after World War II. Nor are
they ominous — indeed, they may be healthy. Even the IMF, which once took a dim view of capital controls, has come around to accepting that they are appropriate in a number of circumstances,27 and it is difficult to conclude otherwise considering the long list of countries that have succumbed to crises after absorbing large inflows of foreign money. As for the trend toward new impositions on international banking, this amounts to much the same thing as shifting the locus of regulation from home countries to host countries — which is precisely what some distinguished panels of experts recommended in the wake of the crisis.28 Requiring overseas operations of mega-banks to maintain adequate levels of capital and liquidity in the countries where they operate may mean that some funds are not invested or lent as efficiently around the world as they might otherwise be. That is not an excessive price to pay for the benefits that would ensue, including minimizing the risks of asset grabs that might turn a bad crisis into a much worse one.

  27 For the latest Fund pronouncement on the subject, see IMF (2012), “Liberalization and Management of Capital Flows: An Institutional View,” November 14, available at: www.imf.org/external/np/pp/eng/2012/111412.pdf.

  28 See The Warwick Commission (2009), The Warwick Commission Report on International Financial Reform: In Praise of Unlevel Playing Fields, November, CIGI and the University of Warwick.