This article was published in Korean by The Korea Herald newspaper on 25 October. It is also available, together with the version in Korean, on The Korea Herald website.
Banking regulation goes in cycles that are punctuated by crises. Typically, a crisis results in regulatory tightening. Then after an extended period of time, memories of the crisis fade away, and policymakers end up yielding to bank lobbyists‘ constant push for loosen the rules. Then banks take more risk as allowed by the weaker new rules, and more often than not, a banking crisis erupts. Then everyone asks why nobody saw it coming.
There is a paradox at play here. Demanding and well-enforced capital requirements actually tend to benefit the banking sector as a whole, as they buttress confidence in the entire system. Even so, however, at least in countries where banks are mostly joint-stock companies owned by private shareholders, bank lobbyists always ask for relaxing the rules, irrespective of the circumstances. In the short term, such lobbying is rational. All things equal, more leverage allows the banks to increase their return on equity and thus to give greater immediate satisfaction to their shareholders and, in most cases given the structure of their compensation incentives, to increase the bankers‘ own remuneration. But in so doing, bankers don’t lobby in their employers‘ long-term interest. (Of course, there could theoretically be such a thing as excessive capital requirements, but analysts who are not somehow beholden to the banks near-unanimously concur that the current levels are far from that mark.)
This cycle has been observed time and again. The great financial crises of the 1930s in Europe and America (the 1920s in Japan) led to a tightening of prudential frameworks that ensured widespread financial stability until the 1970s. From then, a deregulatory cycle started that brought increasingly frequent crises, including that of 1997 in Korea and the major financial crisis of the late 2000s in Europe and the United States which saw the collapse of major institutions such as Bear Stearns and Lehman Brothers in America, Royal Bank of Scotland in the United Kingdom, or Westdeutsche Landesbank in Germany. In response, a new consensus on tighter requirements formed among the world‘s prudential authorities assembled in the Basel Committee on Banking Supervision, which meets regularly in the Swiss city of Basel. The result was a set of rules collectively known as Basel III, issued by the Basel Committee in several batches, the first in late 2010 and the last, nicknamed the Basel III Endgame, in late 2017.
Since the climax of the great North Atlantic crisis only happened 16 years ago in 2008, one would expect that the memories thereof are still fresh enough to avoid a harmful swing of the pendulum in the deregulatory direction. Deplorably, that expectation would be wrong. The indications are multiplying that policymakers are rapidly forgetting the painful lessons that were inflicted on them or their predecessors less than a generation ago.
In the United States, Federal Reserve Vice Chair Michael Barr announced in September that the standards to implement the Basel III Endgame would end up being significantly less strict than earlier proposed. Even though the detailed text has not been published, this announcement has been widely understood as a lack of capacity of the U.S. prudential authorities to resist fierce bank lobbying, in the country‘s present context of extreme political polarization.
The European Union, whose banks collectively hold even more assets than those in the U.S., has recently adopted legislation that is far from fully compliant with Basel III. Even so, there are calls to water it down further. No less an authoritative figure than Mario Draghi, the former president of the European Central Bank, wrote in a recent report that the EU should “assess whether current prudential regulation, also in light of the possible upcoming implementation of Basel III, is adequate to have a strong and international competitive banking system in the EU”. In late September, the heads of the Treasury Departments of France, Germany and Italy have sent a joint letter to the European Commission in which they call for putting “stronger emphasis on the competitiveness of the financial sector, particularly banking, and its capacity to finance the economy”. In both cases, the reference to competitiveness of the banking sector has been understood by commentators as a call to relax capital requirements.
In line with the above-mentioned paradox, the largest U.S. banks are in a much stronger competitive position than their European counterparts ― as Draghi acknowledged in his report ― after a decade during which they were subject to generally higher capital requirements. The latest assessments by the Basel Committee, issued in 2014, had found the U.S. “largely compliant” with the first batch of Basel III rules, while the EU was “materially non-compliant”. (Korea was deemed largely compliant in 2016.) A tweak is that the EU imposes its version of Basel standards on all banks irrespective of size, whereas the U.S. does so only on the very largest. (The Basel Committee only says that its rules are intended for large internationally active banks, without setting quantitative thresholds to define the category.) Predictably, this creates financial stability vulnerability among medium-sized U.S. banks, as the short but highly unfortunate crisis around Silicon Valley Bank and peers disastrously illustrated last year. But local banks are so politically influential in the U.S. that prudential authorities have never been able to expand the scope of Basel application even to banks with total assets well above a hundred billion dollars.
For the European Union, the non-compliance with Basel III is particularly embarrassing. It is overrepresented in the membership of the Basel Committee, which includes no fewer than eight EU countries (Belgium, France, Germany, Italy, Luxembourg, the Netherlands, Spain and Sweden) as well as the EU itself among its 28 member jurisdictions. Of these, seven (all but Sweden) are part of the euro area and thus of the banking union, a framework that has now been in place for a decade and implies that individual euro-area countries no longer have an independent supervisory policy. Furthermore, the EU describes itself as uniquely committed to global standards and the international rules-based economic and financial order. In such a context, the combination of such stark overrepresentation with poor compliance is galling.
In the United States, the adherence to that order is at risk of being further weakened in the years to come, depending of course on the outcome of the forthcoming presidential election. But at the end of the day, jurisdictions such as the U.S. and the EU should not just adhere to Basel standards for the sake of robust global governance. They should do so out of a lucid but also narrow definition of their own self-interest, namely avoiding the devastation of future banking crises. For that, the U.S. should expand the scope of application of Basel III to its medium-sized banks, and the EU should move towards full compliance. Sadly, in the near future at least, there is scarce chance of either doing so.
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