The Challenges Facing Global Capital Requirements

One of the big holes in the financial regulation bill passed this summer was a rule forcing the banks to hold more capital. Although the legislation called for higher capital requirements, no number was set. Instead, it urged reliance on global regulators' conclusions. They are being worked out currently as part of the Basel III accords. Getting all nations to agree on universal rules, however, is proving to be challenging.

Damian Paletta from Wall Street Journal reports on the two major hurdles that remain. One is amount of capital and the other timing of implementation. The big problem is that some (especially European) banks complain that the higher capital levels that some countries like the U.S. are advocating are too high. They say that their banks don't need as much capital because they don't hold as many risky assets.

The idea that a bank's required capital should be proportional to the risk it takes makes sense. Indeed, it's been a central concept to how Basel has defined capital requirements in the past. But it creates a serious problem for regulators. How do you compute the amount of capital firms must hold based on the risk of their assets? Risk, by its nature, isn't always predictable.

In the past, global regulators have relied, in part, on the rating agencies. That didn't work out so well. As we now know, the agencies got quite a few ratings wrong over the past several years, particularly in the sphere of mortgage-backed securities. Those ratings resulted in banks having insufficient capital versus the cushion regulators anticipated would be needed, even in the worst imagined stress scenarios at the time the rules were implemented.

U.S. regulators' reliance on ratings was discussed previously here. A few alternate options provided by the FDIC were discussed in that post, including using credit spreads (market-based risk premium), regulator-defined risk metrics, and firms' internal models. All had their problems.

The Basel committee now faces this same dilemma: how do you satisfy the European banks by rewarding them lower capital requirements for their seemingly more conservative behavior, but insist that other nations which have banks that engage in riskier banking are held to a higher standard? Let's hope the global regulators devise a brilliant solution. At this point, it looks like a pretty difficult problem.