Dec 15, 2010

By Brett King

Why Basel III is bad for finance

The Basel III accord’s stated purpose is:

This consultative document presents the Basel Committee’s proposals to strengthen global capital and liquidity regulations with the goal of promoting a more resilient banking sector. The objective of the Basel Committee’s reform package is to improve the banking sector’s ability to absorb shocks arising from financial and economic stress, whatever the source, thus reducing the risk of spillover from the financial sector to the real economy.
BCBS Consultative Proposal: “Strengthening the resilience of the banking sector”

The intent of the Basel accords must be to afford consumers, shareholders, the corporation, and the ‘banking sector’ at large, more generally protection from shocks, abuse, corruption or intended manipulation. In that respect, Basel broadly takes a position of “trust no one”, and builds into the system a comprehensive framework of understanding, monitoring and mitigating any risk of sufficient intensity that it could do harm to the sector or players.

Reflexive Feedback loops

The issue with this approach is, of course, that by creating a set of rules and by changing the system, this very approach generates a reflexive feedback loop that increases complexity of the processes between customers and the institution, and between the institution and third parties. The more complexity that is built into the system, the greater the likelihood of abuse as complex systems are harder to control or police.

While payments, interbank networks and such may appear inordinately complex, there are those that maintain that such networks produce predictable or measurable behavior in response to specific shocks or trends, but essentially this is through either the emergence of a dominant sentiment (i.e. the old “buy on rumor sell on facts” saying) or through exogenous events.

Tracking complex interactions in the Fed Interbank payments network

While some claim that sentiment analysis through tools like Twitter, might predict the way the network or market will move in the short-term, the problem with Basel III is that its very complexity might possibly have a deleterious effect on the market as a whole, but most certainly on the effectiveness of the institution. The primary concern for institutions will be that Basel III might actually reduce the ability of the organization to respond to shocks in the system, because it might be outside of the approved risk management process. Essentially working exactly the opposite to its intended purpose. However, the implementation of Basel III could actually have a more short-term effect on institutional competitiveness.

Lessons from the regulation of markets

ICBC was the world’s largest IPO in history to-date. There was much discussion over this IPO, but it was telling that ICBC chose, not New York or London to launch their IPO, but Hong Kong. The long and the short of these discussions are essentially that the US market, in particular, is now too heavily regulated to stay competitive on a global stage as a capital market. The US continues to find some momentum around its reputation as the biggest and best market, but a number of proponents of change in the US cite the medium-term demise of the US capital markets as a real risk. For example, Professor Hal Scott, in his paper “Competitive Complacency in the decline of US Public Equity Capital Markets” (May 2007) challenges regulators and the market in this way:

While America’s public equity marketplace is still winning the war as the world’s most dominant marketplace, it is losing many of the key battles to foreign and private markets. America is losing its place of primacy, power and influence as the global leader in public equity capital markets competitiveness. Further, the evidence is equally compelling that New York is losing its place as the dominant center for global financial markets. There is a tremendous price America’s economy may pay for failing to compete sufficiently to stay ahead of its global rivals.

And further in respect to the US regulatory environment

“What we are witnessing is the latest chapter in the evolution of the euromarkets. In the past, US banks moved to London to escape onerous banking regulation and the eurobond market was created in part to avoid US taxes. Now exchanges are moving abroad in part to avoid the US capital market’s regulatory regime. Europe should not be threatened. It is the US that should be concerned. Once a market moves abroad it is difficult to get it back.” – Hal Scott and George Dallas

In a report commissioned by Mayor Michael Bloomberg in 2007, supported by the strategy research firm McKinsey, Bloomberg states the shifting competitive environment in the following way:

“Traditionally, London was our chief competitor in the financial services industry. But as technology has virtually eliminated barriers to the flow of capital, it now freely flows to the most efficient markets, in all corners of the globe. Today, in addition to London, we’re increasingly competing with cities like Dubai, Hong Kong, and Tokyo.” – Michael Bloomberg, Sustaining New York’s and the US’ Global Financial Services Leadership, Jan 2007

So as competition heats up, the heavy regulatory environment of the US and UK markets has not actually helped those markets to be more competitive, in fact, exactly the opposite. The downside of taking a heavier approach to risk mitigation and management is the reduction of competitiveness. In this respect, while dotting the i’s and crossing the t’s Basel III doesn’t contribute positively in any immediately recognizable form to the competitiveness of an institution. In the long-term, we might argue that Basel III is ultimately about insurance, and reducing future risk, which will make you more robust or less risky than your competitors who don’t adhere to the standards. The same argument is made for regulation in markets like the US, but essentially the cost has to be weighed up because in the short-term revenue and competitiveness is taking a hit.

Is there a better way?

So given the cost of implementation, the loss of competitiveness, the fact that Basel III adds inordinately to the complexity of the institution from an organizational structure and process perspective, why don’t we see more of the big banks complaining? Probably because purely the cost of implementing Basel III is prohibitive and it is likely to produce more consolidation of the sector as they snap up banks who can’t afford to comply. There has to be a better way though…

The Basel accords team needs to encourage the reduction of complexity in the system, which in itself creates risk. Rather than enforce new reporting or analysis elements for existing processes, what I’d like to see is a real revolution in process redesign. Let’s look at ways of taking the complexity out of the system, reducing risk by reducing handling, process and silos.

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