November 3, 2010
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In an effort to prevent banks from becoming over-leveraged and insolvent (as has been seen over the last few years), the new Basel III regulatory regime calls for substantially raised equity requirements, among other changes. However, these changes do not include much needed modification to the mechanisms through which risk is measured. This is cause for concern, given that, in search of higher returns under more stringent regulation, banks will be encouraged to invest available capital in more risky (or toxic) assets.
"Basel III is continuing to enable (and even encourage) banks to take on potentially toxic assets..."
Pablo Triana illustrates this scenario in a recent article of his in the Financial Times. Imagine you have $20bn in equity capital and would like to invest in high-yielding assets. Triana states that before the recent changes, capital charges for “adventurous” (or risky) assets were as low as 1% of notional value (the total value of a leveraged position’s assets). So, the $20bn of “funky stuff” could cost you just $200m in up-front capital cushion. Those charges will rise with new regulation. However, the increase would remain modest in comparison with trading assets, whose costs could triple in the future. Returning to the scenario, you would only need about $400m to back your risky (and potentially toxic) bet of $20bn. Basel III is, thus, continuing to enable (and even encourage) banks to take on potentially toxic assets by failing to increase the costs associated with taking on risky positions.
Here’s an easy way to think of this effect: one figure banks measure their performance on is return on equity (ROE). The formula for ROE is simply net income divided by shareholder’s equity. When regulations require banks to maintain higher levels of equity, shareholder’s equity (the denominator in the ROE formula) is increased, which decreases ROE. Naturally, banks will seek to maximize ROE in any way possible. With a larger denominator, the numerator must by equally increased to maintain the same ROE. In order to increase net income, banks will seek more high-return, riskier investments.
Essentially, Basel III cracks down on equity requirements without adjusting for the riskiness of a financial institution’s investments, or for the amount of leverage the institution takes on. While the new framework is a much needed attempt to prevent similar scenarios to the crises of 2007 and 2008, it’s failure to account for these essential factors may prove detrimental down the road.