Mr Stefan Ingves, Chairman of the Basel Committee. Basel III contains the same major design flaw of Basel I & II

Mr Stefan Ingves, Chairman of the Basel Committee and Governor of Sveriges Riksbank in a recent speech has likened Basel II to the Swedish warship Vasa that sank “after sailing only 1,300 metres, on 10 August 1628”… because “the Vasa was well constructed but incorrectly proportioned”.

Ingves states that Basel II “looked impressive on paper. In the Committee's quest for greater risk sensitivity, Basel II introduced the role of internally modelled approaches for credit risk and operational risk and expanded the role of models for market risk.

But things did not work out precisely according to plan. The financial crisis highlighted a number of shortcomings with the banking system and the regulatory framework, including:

• too much leverage, with insufficient high-quality capital funding banks' assets;

• excessive credit growth, fuelled in part by weak underwriting standards and an underpricing of credit and liquidity risk;

• a high degree of systemic risk, interconnectedness among financial institutions and common exposures to similar shocks;

• inadequate capital buffers to mitigate the inherent procyclicality of financial markets and maintain lending to the real economy in times of stress; and

• insufficient liquidity buffers and excessive exposure to liquidity risk. This was in terms of both direct and indirect liquidity risk (for example, through the shadow banking system).”

And according to Ingves now: “The Basel III framework seeks to address the weaknesses I mentioned and provides the foundation for a resilient banking system”.

First, any regulator who approved of capital requirements that allowed banks to leverage their equity 60 times to 1 or more, should be ashamed of speaking of “too much leverage”, “excessive credit growth” and “inadequate capital buffers” as “shortcomings with the banking system and the regulatory framework”. It is not about “shortcomings” it is about a monstrous definite flaw in bank regulations that caused the financial crisis. 

And since Mr. Ingves and his colleagues have apparently yet not understood the basic design flaw of Basel I and II, Basel III will also sink.

The number one problem is that regulators have never defined what was the purpose of banks. Had they done so, they would have had to include that of allocating bank credit efficiently to the real economy. And, had they spelled out that purpose, then they would not have been able to use credit-risk weighted capital requirements for banks. 

Allowing banks to leverage their equity and the support they receive from society differently, based on credit risks, results in banks being able to earn higher risk adjusted returns on equity on some assets than on others. Because that did of course totally distorts the allocation of bank credit.

And then Ingves says: “In addition, another important lesson is that the quest for perfection - or in this case, ever-more precision in measuring risk - can be illusory. Spending years on developing a "perfect" risk-sensitive framework may not deliver the results we would hope for. Instead, having in place multiple regulatory constraints provide more safeguards against the risk of a defect in any single element of the framework.”

Once again he evidences not having understood the real problem. It is not about the precision in measuring the risk. Since banks already clear for risks with interest rates and size of exposures, forcing them to re-clear for the same risk in the capital, means that credit risk will be excessively considered. And any risk, even if perfectly perceived, causes the wrong actions, if excessively considered.

And then Ingves says: “Instead, having in place multiple regulatory constraints provides more safeguards against the risk of a defect in any single element of the framework.”

And once again he shows he does not get it. Banks are to hold capital against unexpected losses, and unexpected losses cannot be derived from expected risks. The most that can be said in that respect is that the safer an asset is perceived to be the bigger is its potential to deliver unexpected losses.

Mr Ingves concludes with “The Committee's ongoing policy reforms are grounded in trying to balance the simplicity, risk sensitivity and comparability of the risk-weighted framework.”

No! We, and especially the generations to follow us need a banking system that believes in the future. Capital requirements based on credit risk gives banks the incentives to stay away from financing the “risky” future and to keep solely refinancing the “safer” past. God make us daring!

May I humbly suggest a different course?

For a start the same basic capital requirement for all assets, like 8 percent, to cover for unexpected losses, like those for instance that can be caused by regulators not knowing what they are doing, cyber attacks, or an asteroid hitting earth. Of course one would have to design a very careful course for taking banks from here to there since it is fraught with a lot of dangers for the banks and the real economy.

Then and even when it is arrogant and dangerous to interfere in any way with the market, if you must, why not make some capital requirements for banks based on purpose weights, like for instance the SDGs? In such a case we would allow banks to earn a little higher risk adjusted returns on equity when they are doing something that society might want them to do, and not like now, just when they avoid credit risks.

Would the bank system become unstable because of that? Not at all, major bank crisis have never resulted from excessive bank exposure to assets that were perceived as risky when they were put on the balance sheet… they have always resulted from excessive exposures to something wrongly believed to be safe… or to something that was a safe haven but became dangerously overpopulated.

PS. Ingves states with relation to Basel II: "Six years were spent on developing this new framework. Hundreds were involved - central bankers, regulators and supervisors, not to mention the untold bankers, academics and others who commented on the Committee's proposals. Perhaps the equivalent of 40 acres of timber were consumed in the form of internal BCBS papers, consultation papers and responses received by stakeholders!" No! At the end of the day, it was something brought out by the members of a very small mutual admiration club.

PS. Mr Ingves. I recently suggested Mario Draghi he should take a sabbatical year in order to study the mistakes of current Basel bank regulations. You should too!