Less than 15 months after the world’s most recent banking crisis, regulators in the US and Europe are already poised to roll back reforms aimed at reducing the risk of further financial disasters. It’s a serious mistake.
At issue is where banks get their money. Most is borrowed from depositors and other creditors. If it’s not paid back on time, broader distress can ensue. The rest, known as equity or capital, comes from shareholders who stand ready to absorb losses. The more of the latter banks have, the better they’re able to inspire confidence and keep lending even in the worst of times.
The problem is that executives prefer to employ as little equity and as much debt as possible, because this maximizes government subsidies and boosts measures of profitability in good times.
After the 2008 subprime-mortgage crisis, regulators everywhere recognized that capital had been woefully lacking. Working through the Basel Committee on Banking Supervision, they agreed to impose new standards known as Basel III. Equity levels rose significantly, peaking at about 7% of assets among the largest American banks — though this was still less than half what research and experience suggest would be needed to weather a severe crisis. Europe was a laggard, barely exceeding 5% of assets (according to the most comparable measure).
Both Europe and the US have now entered the last stage of the Basel reforms, the “Basel III endgame.” It’s aimed primarily at tightening requirements for “risk-based” capital ratios, which seek to account for the riskiness of a bank’s assets but have proven vulnerable to manipulation. The European Union has mostly agreed on a watered-down version — against the advice of economists and regulators — that comes into force in January 2025. Last year, US regulators put forth a somewhat more ambitious proposal, which might’ve boosted simple equity-to-assets ratios at the largest banks by about a percentage point.
Unfortunately, that effort has stalled, thanks partly to design flaws and partly to aggressive lobbying by banks. In response, some officials in Europe — from Brussels bureaucrats to French President Emmanuel Macron — are suggesting that the EU should delay or relax its rules if the US doesn’t act, on the grounds that it will be putting its own banks at a disadvantage.
Such arguments aren’t persuasive. Fragile banks aren’t a competitive advantage, as the recent demise of Credit Suisse Group AG and trouble elsewhere in Europe amply demonstrate. European institutions still have less equity than their poorly capitalized US counterparts. At current levels, any increase would deliver a net economic benefit. The more banks have, the lower their costs of equity and debt funding should be.
The point of the Basel reforms was for the world to move simultaneously toward a stronger global financial system. Both the EU and the US must recognize that their decisions have consequences beyond their borders. A race to the bottom won’t end well for anyone.
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