G20 and Reforming Banking Regulation
This post was written by Karl Whelan
The communiqué for the latest G20 summit is available here. It contains lots of the usual waffle about co-operation on this that and the other, but I think the most important element of the discussions relates to the reform of banking regulation.
The communique’s references to reforming executive compensation will probably attract the most attention. Reforms of this type are a good thing though I suspect that getting them implemented in practice may be tricky. More important, I think, are the proposals to reform capital standards. The relevant extract from the communiqué is as follows:
The national implementation of higher level and better quality capital requirements, counter-cyclical capital buffers, higher capital requirements for risky products and off-balance sheet activities, as elements of the Basel II Capital Framework, together with strengthened liquidity risk requirements and forward-looking provisioning, will reduce incentives for banks to take excessive risks and create a financial system better prepared to withstand adverse shocks. We welcome the key measures recently agreed by the oversight body of the Basel Committee to strengthen the supervision and regulation of the banking sector. We support the introduction of a leverage ratio as a supplementary measure to the Basel II risk-based framework with a view to migrating to a Pillar 1 treatment based on appropriate review and calibration.
All of these are good ideas but the proposals are completely lacking in specific details as to how exactly they would be implemented. There is a bit more information in this background document prepared by the Financial Stability Board but not much. The absence of specifics suggests that the hard negotiations lie down the road.
Take the leverage ratio for instance. Some of the financial institutions that had substantially over-stretched themselves prior to the current crisis were ostensibly well-capitalised according to the Basle risk-weighted-capital standards. However, it turned out that many of their investments were far riskier than had been understood and when things went wrong, they ended up undercapitalised or insolvent. A maximum leverage ratio acts as a sort of “backstop” (Lord Turner’s phrase) to the risk-weighted capital ratio: Given an amount of equity capital a bank holds, this ratio sets the maximum size for total bank assets, independent of how risky the assets are. Whether this is an effective tool in preventing banks getting into trouble depends on the size of the ratio and, of course, on the specific definition of capital used in the denominator.
Perhaps unsurprisingly, former IMF Chief Economist Simon Johnson isn’t impressed, viewing the Europeans as likely to be foot draggers in this process, and thus hindering rather than helping the process of raising capital standards in the US. He links to a similarly sceptical piece from Joe Nocera of the New York Times.
On a related issue, I have been appointed to the “Monetary Experts Panel” which briefs the European Parliament’s Monetary and Economic Affairs Committee in relation to its Monetary Dialogue with ECB President Trichet. Last week, I submitted a briefing paper on “The ECB’s Role in Financial Supervision” which discussed some of the challenges associated with macro-prudential regulation in Europe. It and some other papers submitted to the committee are available here.