Taking A Long, Hard Look at Basel II

Recently I was asked to testify before the U.S. Senate Committee on Banking, Housing, and Urban Affairs to address the development of new Basel capital accords. Though at the beginning I admitted to the committee I was a bit rusty at testifying, I gave it my best and told them what I thought about the proposed Basel II standards.

To lend some perspective, Basel I had as its objective setting adequate minimum capital requirements around the world (I was there and participated in the process). To achieve this, minimums standards had to be relatively simple and calculated uniformly. In addition, they were designed to increase capital worldwide. This objective has been met.

By contrast, Basel II standards are not simple, not likely to be uniformly calculated around the world, and will probably reduce minimum capital requirementsu00e2u20ac”an understandable result.

I say this because our experience with capital standards during the banking problems of the 1980s and 1990s taught us that the minimum capital requirements at that time were too low to meet unusual stress. Two of our largest banks would have failed with any reduction in required capital, yet today’s Basel II reduces capital requirements substantially, especially for these large banks.

The United States’ experience with economic models as a basis for regulatory standards is pretty much limited to our various government-sponsored enterprises. Unfortunately, that method has not worked well because of nonmodeled facilities (improper accounting, etc.). The second-greatest risk to financial institutions (after asset-quality problems) is interest rate risk, which is not a part of the Basel II proposed models.

As Chairman Greenspan noted at his last appearance before Congress, models will be an excellent basis for setting regulatory standards when they are perfected, but they most certainly are not perfect now and won’t be for a long time to come. Also, these models are subject to error, particularly if they are based on the good banking times of the last 10 years.

Basel II standards will cause competitive advantages and disadvantages based on the size of the institution, the country of origin, and the judgments of its creators. This is the opposite of what minimum world banking capital standards should do.

Economic models are useful in determining capital requirements and product pricing, and they should be encouraged with the understanding that they provide useful information for bank management and regulators. However, they should not determine uniform minimum capital standards for the world’s banks. They can provide useful information that becomes a part of the process.

The old adage “If it ain’t broke, don’t fix it” might be modified in this case to “If it needs adjustment, provide the minimum adjustment needed to improve performance.” This is what U.S. regulators seek in proposing Basel I-A (yet to be published).

Finally, I quote Professor Paul Romer who teaches at Stanford University’s Graduate School of Busines: “Of course we understand that even in normal times, the best model is just a guide. If something extraordinary happensu00e2u20ac”like either Russia goes under or the stock market goes down by 20%, anyone with a modicum of common sense knows that the model’s not going to be a reliable guide.”

In the end, I hope my past experience and thoughts on this matter will help the Senate Banking Committee make the recommendations necessary to structure the new capital accords in the most useful way possible for the global banking marketplace. I must have made some impact, because at the end of my testimony I received a compliment from Senator Paul Sarbanes, the committee chairman, who said, “Seidman rusty is better than most people well oiled.”