Ifo Viewpoint No. 118: Basel III: Stricter and fairer

Hans-Werner Sinn
Munich, 21 October 2010

The new capital requirement rules for banks reduce the bias against small businesses, but they still offer insufficient protection against future crises. What does the new “Basel III” bank regulation mean? Will it suffice to prevent the next crisis and a misrouting of capital flows? Or will it imply high capital costs and result in a drag on the economy? What can we expect?

The Basel III agreement calls for an increase in mandatory reserves relative to risk weighted assets (tier 1 capital) from four to six percent by 2015 – and to 8.5 percent by 2019. Basel III also calls for testing a general balance sheet capital asset ratio of three percent, which would limit banks to a leverage factor of 33. Some banks must now take action. Before the crisis, Deutsche Bank, for example, had a capital asset ratio of only 1.9 percent. In anticipation of the new regulation it reduced its balance sheet, which in the first quarter of 2008 still amounted to 2.3 trillion euros, to 1.5 trillion euros at the end of last year. In addition, it carried out a 10-billion-euro capital increase, raising its capital reserves by about one quarter.

Such reactions are welcome. The banks must now build up a larger capital buffer for bad times to reduce systemic risks. Bank stockholders will now bear a larger portion of the bankruptcy risk, prompting them to induce their bank managers to pursue more cautious business models.

The new regulations are by no means sufficient, however. Basel III is stricter than Basel II – but still not strict enough. In the financial crisis many banks suffered far greater losses than the size of the buffer now required. By the beginning of 2010 Citigroup had lost about 6 percent of its balance sheet total as a result of write-offs of toxic financial products; for Wachovia it was 13 percent, Merrill Lynch 6 percent, Washington Mutual 14 percent, the Bank of America five percent and Wells Fargo 8 percent. For the entire US banking system the write-offs amounted to 4.7 percent of the aggregated balance-sheet total. In Europe the British HBOS and the Bavarian State Bank (LBB) lost about three percent of their original balance-sheet total; the semi-public IKB suffered a loss of 19 percent. Even Switzerland’s UBS lost 2.7 percent – 0.8 percentage points more than it had in capital reserves. For nine large international banks, the write-offs of toxic financial receivables exceeded the value of their capital reserves before the crisis.

Some commentators fear that stricter capital requirements will damage national economies by making credit more expensive. This fear is unfounded. Firstly, after an increase in capital requirements the banks’ lenders will be satisfied with lower interest rates, as they now bear a smaller risk. Secondly, an increase in lending margins would not be damaging but useful, since it would result from making it more difficult for the banks to pass on their losses in a crisis to the taxpayers. If something becomes more expensive because a negative externality is internalised, this is never a disadvantage for the economy.

It cannot be assumed, however, that interest rates in the economy will rise on balance. An alleviating factor is that with the introduction of a leverage ratio, a major constructional flaw of the Basel system has been addressed. This flaw lay in the random determination of weighting factors for the risk-weighted assets at which the tier-1 capital rate is aimed. Even for loans to well-managed small businesses, the banks needed two-and-a-half times the capital they needed for the purchase of structured US securities or loans to other banks. For loans to states and for offshore transactions with special purpose vehicles there were no capital requirements at all since the risk weights were zero. This state of affairs made no small contribution to the crisis, since it artificially raised the interest rates for small businesses and artificially lowered the rates for structured securities and for government bonds. Small businesses paid the price that enabled Ireland, Portugal and Greece as well as US investment banks to tap German savings more cheaply.

That was not only unfair but also dangerous because it intensified the misrouting of capital flows that prevailed before the financial crisis. The fact that Germany in the past 15 years had the lowest investment rate of all OECD countries and exported most of its savings can also be seen in this connection.

Basel III has not changed the risk weighting. In spite of a more critical assessment of countries by the rating agencies, the loans that are granted by the banks to overextended countries such as Italy, Ireland, Spain, Cyprus or Belgium still have no risk weighting. Only loans to Greece and Portugal are assessed in the Basel system as special risks because of the massive downgrading by the rating agencies. Nonetheless, the leverage rate will now force the banks to maintain capital reserves also for their loans to states. This will help small businesses, since in future states will have to pay higher interest on their sovereign debt, thereby making a significantly higher contribution to bank profits than before. Competition among banks will result in the higher interest rates on government paper leading to lower interest rates on business loans. At last a step in the right direction.

Hans-Werner Sinn
Professor for Economics and Public Finance
President of the Ifo Institute

Published as “Strenger und fairer”, Wirtschafswoche, no. 39, 27 September 2010, p. 45.