Stefan Ingves: Basel III is simpler and stronger
Op-ed by Mr Stefan Ingves, Governor of the Sveriges Riksbank and Chairman of the Basel
Committee on Banking Supervision, published in the Wall Street Journal, 15 October 2012.
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The economic cost of the global financial crisis during the past five years has been
frighteningly large. One clear lesson from the crisis is that regulatory capital requirements for
the banking system were too low. Or in other words, leverage was too high.
Under the pre-crisis rules, banks were allowed to increase their leverage to unprecedented
levels. This increased risk in the financial system and when the crisis hit, the implicit
guarantees resulted in massive public bailouts around the globe.
The Basel Committee's capital reforms, known as Basel III, substantially raise capital
requirements from pre-crisis levels to reduce the probability of bank failures and the
associated risks to taxpayers and to financial stability.
Recently, much has been made of the perceived shortcomings of Basel III. Some argue that
Basel III, which comes into effect next year, is not enough. Others argue that Basel III is too
complex and should be replaced by a simple leverage ratio, calculated as tangible equity to
non-risk weighted assets.
In my view, the Basel III agreement fundamentally enhances national and global financial
stability by both raising the level of capital required by banks, and by simplifying the
regulatory framework.
It is no small task to reach a global consensus on these often quite technical matters. Part of
the consensus is that Basel III should be seen as a set of minimum requirements. Hence,
countries are free to impose more stringent rules if they wish.
But we should not underestimate how Basel III strengthens bank-capital adequacy rules. A
fundamental feature of the new framework is the significant increase in required minimum
capital levels. All banks must hold common-equity capital of at least 7% of their risk-based
assets, compared with only 2% previously.
In the event of a credit boom, banks under Basel III would potentially need to hold a further
2.5% in common equity, bringing the total to 9.5%. Finally, the most systemically important
banks must hold up to 2.5% in additional common equity. That is a total of 12%, a sixfold
increase from pre-crisis levels for these institutions.
The Basel Committee supports a regulatory framework that is both prudent and as simple as
possible. Hence the Basel III agreement introduces several simplifying changes to the
regulatory framework. For instance, the definition of capital now focuses on tangible common
equity, the truest form of loss-absorbing capital. Moreover, all components of the capital base
and associated deductions such as goodwill or deferred tax assets must be disclosed in a
fully comparable manner.
By standardising and simplifying the measure of capital, Basel III makes the regulatory
framework easier to understand, and will enable market discipline to work better.
Another important step has been the introduction of a non-risk based leverage ratio as a
supplement to the risk-based requirement. This is a "belt and suspenders" approach to
capital regulation. The leverage ratio will help contain the buildup of excessive leverage in
the system, serving as a backstop to the risk-based regime and safeguarding against banks'
attempts to "game" the risk-based requirements.
Equally critically, the risk-based framework helps ensure that banks do not game the
leverage ratio. Let's not forget that simple measures like a leverage ratio have been in place
in the past and did not alone prevent banking failures.
Risk-weighting is difficult but vitally important. Therefore the Basel Committee is in the
process of reviewing the risk-weighting regime of the capital framework to ensure that it is as
simple and comparable as can be while still capturing the risk profile of banks' varied asset
portfolios.
Complexity is a byproduct of the desire, among regulators and banks, for risk sensitivity. Risk
measurement will never be perfect. Simplicity, however, can sometimes come at a cost.
Ignoring risk does not make it disappear. Without measuring risk properly, we may allow it to
build up undetected.
Operating only with a non-risk-based leverage ratio creates incentives to shed safe assets
and to increase the riskiness of asset portfolios; to forgo risk-reducing hedging strategies
because they could result in higher capital requirements; and to engage in off-balance sheet
activities and other sophisticated structures that expose a bank to contingent risks. This is
likely to increase the aggregate risk in the economy and thereby create global financial
stability concerns.
The lesson, therefore, is not to rely on either risk-based or non-risk-based measures alone,
but to have each reinforcing the other. A combined approach, as Basel III introduces, is
better than any single approach.
I believe Basel III strikes a reasonable balance by strengthening overall bank-capital
requirements while continuing to recognise that there are a wide range of risks within a
bank's business. Going forward, the Committee will look to further simplify the framework
while ensuring that it appropriately measures and responds to the risks it is supposed to
mitigate.