What is Basel III exactly, and why should you care? First let's talk about why a change was needed. Due to the out-sized risks that banks took in the years leading up to the recent financial crisis, they ended up needing huge cushions of capital to stay afloat after their losses. That crisis produced "$4 trillion in bank losses, tens of millions of foreclosures, and a string of taxpayer bailouts," as The Wall Street Journal puts it.
During those bubble years, banks were borrowing as much as $50 for every dollar of their own capital -- yielding a ratio of capital to assets of 2%. Another way of thinking about this is that a 2% decline in the value of the banks' assets would wipe out their equity completely. That proved to be a trivial margin of safety -- hence the need for that $23.7 trillion (in cash and guarantees) federal bailout.
Clearly, a 2% capital ratio was far too lax. Basel III boosts the requirement considerably.
A Good Idea, but Postponed Too Long
The new rules require some explanation. The Journal reports that the new rules require so-called Tier II capital to be at least 10.5% of so-called risk-weighted assets, and of that 7% must be common equity. Tier II capital includes different kinds of financial instruments, including the most solid -- common equity -- and some shakier ones, known as hybrid securities. Risk-weighed assets, meanwhile, refers to the idea that chancier investments -- like mortgages and loans -- require more of a capital buffer than safer ones like U.S. government bonds.
The bad news is that these new requirements don't go into effect until 2018. Even worse, banks can wait until 2023 to replace their dodgier hybrid securities with common equity. And this delay matters enormously.
The Circle of Economic Life
The nature of economic cycles is that unless otherwise regulated, bank capital goes through cycles of expansion and contraction about every eight to 10 years. We appear to be in the early stages of such a cycle now. Here are its six steps:
- Rebooting. Governments lower interest rates and otherwise add liquidity to the economy even as they crack down on the excess lending that put the economy into a tailspin.
- Accumulating Capital. All the efforts to boost liquidity reload the banks' balance sheets with capital, but they hoard the capital rather than lending it out.
- Jumping Back Into Risky Waters. Eventually, the banks hold so much capital that some more aggressive institutions start to take greater risks by lending it out, because their returns on capital invested in the most conservative assets are seen as too low.
- Following the Leaders. Once those aggressive banks start lending out the money, the rest of the pack follows.
- Venturing Deeper Into the Risk Frontier. The leaders and followers repeat steps 3 and 4 -- taking on ever riskier borrowers -- until significant amounts of money has been lent out to a big group of people who won't be able to pay it back.
- Collapse. This leads to the final step: A sudden contraction as lenders are forced to recognize that the risk they took on is far greater than they had originally thought.
If Basel III's requirements for increased capital don't go into effect fully until 2023, we can expect one or two cycles of economic expansion and collapse between now and then. And we're setting ourselves up for a monster of a cycle this time around since central banks have unleashed record levels of liquidity.
Even when the new requirements do go into effect, the challenge for regulators will be to use their power to force banks to boost their capital enough when times are good to protect the system from a possible future collapse. Bubbles generally peak after people conclude that "it will be different this time," and start acting like they can keep the party going indefinitely.
Unfortunately, it's never different.