WE MUST RETHINK BASEL, OR GROWTH WILL SUFFER / THE FINANCIAL TIMES COMMENTARY & ANALYSIS ( VERY HIGHLY RECOMMENDED READING )

We must rethink Basel, or growth will suffer

By Vikram Pandit

Published: November 10 2010 21:27

Leaders of the Group of 20 economies meeting in Seoul must decide whether to recommend additional capital and liquidity requirements for banks above and beyond those proposed by the Basel committee. They should proceed cautiously. There is a point beyond which more is not necessarily better. Hiking capital and liquidity requirements further could have significant negative impact on the banking system, on consumers and on the economy.


Basel seeks to address some of the reasons why the financial system fell into crisis, including over-leverage, pro-cyclicality and unlevel playing fields. On the issue of leverage, I support Basel’s new higher capital requirements and expect my company to meet and exceed them well ahead of schedule. I believe they will make the system safer – in part because changes in risk weightings make the new requirements higher than they seem. Under Basel III the advertised 7 per cent is really more like the old 12 per cent. That is a substantial level and, with proper regulatory supervision, more than enough to stabilise the banking system.


But in the two other areas, risk management and calibration, the Basel architecture is silent, does not go far enough or makes the problem worse. It worsens the pro-cyclicality problem, for instance, by reducing capital requirements in good economic times – an inducement to banks to begin over-leveraging again once they feel the worst is behind them. Improper calibration also fails to level both the institutional and geographical playing fields. Different kinds of institutions are regulated differently (and some not at all) while different countries are allowed to implement as much, or as little, of Basel as they like. These unlevel playing fields will chase capital out of the highly regulated formal banking sector and away from countries with strong rules and into new, less regulated or unregulated shadow banking systems. Overall risk in the financial system will rise. More capital will not solve either of these problems.


Basel also makes matters worse for consumers. The latest rules judge risk largely on the basis of credit scores and data from the worst outlier years of the recent crisis. A consumer or small business seeking a loan will therefore be assessed largely on what happened from 2008 to 2010. Little weight is given to future prospects. This history-based approach will raise capital costs for a large group of consumers and many small and medium-sized businesses – the primary job creators in our economy. No one disputes that riskier loans should be backed by higher levels of capital. But basing risk measurements almost entirely on data from the crisis years will mean that the “haves” who need credit the least will get the most, and pay the least for it. The “have-nots” who need credit will be those hurt most.


Finally, Basel’s effect on the economy, and in particular on aggregate demand, could be severe. The flipside of lowering capital requirements for good times is raising them in bad – exactly when lending is needed the most. Credit will shrink, businesses will wait to hire and expand, and consumers will further retrench. The last thing the global economy needs is another economic dampener. Yet the bidding war we are seeing in which certain countries try to outdo Basel and one another with ever-higher capital levels amounts to exactly that.


It is understandable in the wake of the crisis that regulators prefer to err on the side of caution. But double-digit ratios will undermine lending, slow capital formation, lower demand and restrict growth. They will impede recovery by raising the cost of credit precisely when it is needed most. And it is not even clear that these higher requirements will make the broader financial system safer.


Striking the right balance between systemic safety and economic vibrancy should be our goal. The pendulum is in danger of swinging too far in one direction. Thankfully, the process is not over. Much remains to be determined, from lending limits to liquidity requirements. We need to take a page from the open and transparent debate that produced Dodd-Frank in the US. The issues at stake could hardly be more important – and are vital matters not just for regulators but even more so for world leaders and finance ministers. Rather than try to outdo the aspects of Basel that are already sound, G20 leaders have an opportunity to fix what is still broken.

The writer is Citigroup chief executive


Copyright The Financial Times Limited 2010.