G20 Endorses Basel III

Finance ministers and central bank governors of the G20 nations met in South Korea over this past weekend for their 2010 summit. Key items on the agenda included the uneven global economic recovery, the need for fiscal discipline amongst the most advanced economies, and an agreement on managing currency conflicts. Also on the docket, the G20 sought to endorse the Basel III banking reforms agreed upon in September by Group of Governors and Heads of Supervision of the Bank of International Settlements (BIS).  In its statement, released on Saturday, the G20 ministers offered this endorsement, stating that they “… welcome and commit to fully implement within the agreed timeframe the new bank capital and liquidity framework drawn up by the Basel Committee …”

Inside the Accord

The confirmation of the Basel III effort by central bankers in September was generally greeted with relief by the banking community and by investors. The provisions of the new accord are less stringent than originally anticipated. Similarly, the extended implementation time frame set by the Basel Committee affords banks considerable leeway in working toward higher capital requirements. Bank stocks in the United States and Europe rallied the day after the announcements in Switzerland, signaling the accord's limited impact on the near-term outlook for the sector.

Under the terms of the Basel III framework, banks' minimum total capital, the definition of which has been in play throughout this process, rises sharply, from 2 percent to 7 percent of risk-adjusted assets. Supplemented by a conservation buffer intended to help institutions absorb losses during periods of unusual financial stress, capital rises further. An additional countercyclical buffer will range from 0 percent to 2.5 percent, according to country-specific circumstances and in support of "macroprudential" goals in constraining the growth of credit.

Why 2.5 and not 3 percent? At play is the art of politics as much as any science of risk management. Exact numbers aside, the Basel Committee believes that the changes support its goal of reducing the pro-cyclicality of credit by improving the quality and quantity of banks' capital cushions. Still, few changes will be immediate. A phase-in period begins in 2013. The common equity requirements come into force in 2015; the additional buffer, in 2019.

As compared to the antecedent Basel II accord, the new framework has been negotiated far more quickly, is far simpler and reflects agreement among a larger number of participants. And while the Basel Committee has been keen to focus attention on the need for countercyclical capital buffers, these differences in the two accords highlight shifting regulatory priorities over time as well.

What’s Next

Basel III's extended implementation time frame is a controversial concession designed to avoid an abrupt deleveraging across the pond. In the United States, on the other hand, analysts and some policymakers argue that the largest institutions already meet the new requirements. The updated thresholds may not fundamentally alter their profit calculus, but they are impactful. JPMorgan, for example, has estimated that its risk-weighted assets will rise by approximately 25 percent. Herein rests the challenge. Basel III functions reasonably well as a blunt instrument for ensuring a deeper capital cushion for individual banks and the global banking system. But in doing so, it may also threaten to constrain some classes of banks that would otherwise be easing credit availability to commercial real estate. Safety and soundness is fundamental to the long-term health of the financial system and economy. But ensuring sufficient and appropriately-priced credit to avoid destructive deleveraging must also be a macroprudential goal. From this vantage point, the time horizon for implementation of the accord may be problematic. Over the next five years, as key provisions come into force, the demand for credit to ensure some modicum of success in refinancing maturing commercial real estate debt – outside of the largest and most liquid markets, in particular – might easily outpace growth in credit supply.