In the wake of the new global capital requirements unveiled through the Basel III Accord over the weekend, many proponents of stricter standards are pleased. As explained in this explanatory flashcard on the new rules, the changes are relatively aggressive. They should make for safer banks that can better absorb losses when deep recessions and financial crises hit. But some critics of large financial institutions are concerned with the ample time permitted for banks to comply. They have until January 1, 2019 before the new standards must be fully implemented. Could this pose a problem?
Nobel Prize-winning economist Joseph Stiglitz thinks so. Bloomberg quotes him as saying:
While it's understandable, given the weaknesses and the failings of the banking system, that one would want to be slow in introducing these increased capital requirements, delay is exposing the public to continued risk. Given the high levels of payouts in bonuses and dividends, it seems a little unconscionable to continue putting the public at risk with an argument that they cannot more rapidly increase their own capital.
So the idea here is that banks will continue to pocket their profits instead of use the money as a shock absorber until the capital requirements are finalized. So they'll continue to take big risks as long as possible to collect big bonuses while they still can make a healthy return on their relatively lower level of capital required. That, Stiglitz believes, is part of what led to the financial crisis --- precisely what the new capital requirements are trying to avoid. This worry might be a little exaggerated, however.
Most Big Banks Already Close to Compliance
Felix Salmon notes one reason not to fear Stiglitz's concern:
But the big bonuses that Stiglitz is worried about are overwhelmingly paid out by banks which would be compliant with these new Basel III rules even if they were implemented tomorrow. And once a bank is compliant, the market will punish it severely if it slides back during the phase-in period.
When these big banks began healing after the financial crisis, they felt pressure to demonstrate their financial health to the market. So they ramped up their capital levels well beyond the old Basel standards. As Salmon notes, many of them would either already be compliant with Basel III already or aren't far from it.
Other Big Banks Will Comply as Quickly as Possible
The market itself will also work as a check on this timeline. Since it knows the standard to which banks must now adhere, they will work very quickly to get there on their own. They will want to demonstrate their stability relative to their competitors. This is precisely what we saw as banks began to regain their footing after the financial crisis: they all quickly raised capital to pay back their bailout and prove their strength.
I spoke with Richard Spillenkothen, the former lead banking regulator for the Federal Reserve through 2006 who served on the Basel Committee when at the Fed about the timeline. He said this outcome was likely:
I think you're going to see financial markets will naturally provide some incentive and pressure to organizations to meet the standards earlier than allowed by the transition arrangements. So to some degree, there will be incentive from market signals in terms of what the market participants are urging, rating agencies, and those kinds of things, but also senior management of banks want to be able to say, "We need the standard now, we're not waiting for five years or four years or three years." So you'll see some market pressure to speed up compliance with the standards.
Much Phased in by 2015
Moreover, the timeline imposed by global regulators won't simply let banks function as is until 2019 comes. Instead, there's a very carefully defined timeline that contains various milestones that they must hit to show that they're making progress towards this end. Spillenkothen noted this as well:
There are a number of steps, benchmarks, and milestones. You've got meet this by that time, and this other thing by that time. What that suggests is that there was perhaps some trade-off between, maybe we'll extend the transition period a bit beyond what some might have favored, but we want to have meaningful interim benchmarks and milestones and targets so that regulators can track the progress of banks towards meeting the standards.
Here's a chart showing precisely how that will work (click for bigger version):
As you can see, by the start of 2015, banks will be much of the way there, only their Capital Conversion Buffer of 2.5% won't yet be required. That will be just over four years away from when the G20 formally is expected to approve the Basel II Accord this coming November.
Another Financial Crisis in the Next 8 Years?
Finally, you have to ask yourself how likely it is that excessive risk taking on the part of banks is really likely to cause another financial crisis in the next eight years. Really, the period banks would have to engage in such shenanigans will be even less, because as just mentioned they will have to begin to comply with higher requirements much sooner than that. The financial collapse that took place in 2008 wasn't created overnight. It was building for at least that long, and was also made possible through a great deal of regulatory loosening over a few decades, much have which has since been reversed. It would be quite a feat for banks to screw things up so badly again, so soon and so quickly after such a deep crisis hit.
In fact, the timeline Basel III provides is a prudent approach. It allows struggling banks ample time to ramp up their capital without harming their business, but still forces them to make gradual progress towards the desired end. Meanwhile banks that can comply earlier will likely do so well ahead of schedule.