Time to set banking regulation right

In an article on Vox EU, Jacopo Carmassi and Stefano Micossi observe that it is time to set banking regulation right and address three critical shortcomings of the Basel prudential rules.

What caught your humble blogger's attention was the way the authors described the three critical shortcomings as being the result of opacity.

Together, they make the case for requiring banks to provide ultra transparency and disclose on an on-going basis their current asset, liability and off-balance sheet exposure details.

Excessive leverage and risk-taking by large international banks were among the main causes of the 2008–09 financial crisis and the ensuing sharp drop in economic activity and employment. Enormous costs were borne by taxpayers and societies at large. 

In reaction, world leaders and central bankers undertook to overhaul banking regulation, including by rectifying the failed Basel prudential rules with the new Basel III Accord. Many scholars have commented on the proposed reforms, especially the US’s Dodd-Frank Act (eg Acharya and Richardson 2011). 

Europe is now considering how to transpose the new Basel III Accord, with the proposed Capital Requirements Directive IV, now before the European Parliament and Council. 

In our study published last week (Carmassi and Micossi 2012) we argue that these reforms are not enough; they fail to correct the three critical shortcomings of Basel prudential rules, namely:

• Reliance on banks’ risk management models for the calculation of capital requirements.

These are opaque and open to manipulation.

Hence, bank capital is meaningless.  A point that the OECD also made.

• Lack of public accountability of supervisors.

Given the opacity of solvency rules, the supervisors may stand beside their regulated entities in delaying loss recognition and ‘gambling for resurrection’, thus raising the ultimate cost of bank failures for taxpayers.

Hence, the selection of the Japanese model for how to address a bank solvency led financial crisis over the Swedish model.

• Weak market discipline.

Clear metrics of capital strength are not available to investors and the public at large.

Without ultra transparency, there is no market discipline as market participants do not have access to the data they need to independently assess the risk of each bank and to subsequently adjust the amount and price of their exposure based on this assessment.