No sooner has the warm soil settled on the grave of Basel II (see Basel II - Obituary), than previous friends and colleagues are slinking out of the shadows to discredit his memory.
In a recent web-cast, one of these Judas, Nancy Hunt head of capital markets policy at the FDIC (Federal Deposit Insurance Corporation) made the amazing claim that, had Basel II been implemented on time in the USA, "the US financial system would have been even worse off and required additional government intervention". Now remember that this comment comes from a senior official at a regulator that had responsibility for supervising some of the most egregious offenders in the 'sub prime' market, such as Countrywide, and has had to take over almost 90 failed banks already this year. Ms Hunt appears to be arguing that having no effective regulation is better than having some regulation. [Nurse, book one more place in the funny farm, please!]
More subtle, but more deadly to Basel's reputation, were the silky smooth words of the head of UK financial regulator (FSA) and member of the House of Lords, Lord Adair Turner, who in a review of the financial crisis, drove a dagger into the dying Basel, arguing that "the quality and quantity of overall capital in the global banking system should be increased, resulting in minimum regulatory requirements significantly above existing Basel rules" [I.e. Basel got it wrong!]
The closest disciples of Basel, the Basel Committee, have also been turned into Doubting Thomases and, getting a flea in their ear during the latest G20 Finance Ministers' meetings, rushed off to develop a new '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." [I.e. Keep it simple Stupid].
If Basel II could only get a sub-committee together to calculate the minimum amount of angular momentum required, he'd be spinning in his grave.
But Basel is not completely friendless. The redoubtable Christine Lagarde, the French Finance Minister, has demanded that Basel II be implemented fully and immediately in all jurisdictions, especially the USA. However, remembering that Mme. Lagarde has just presided over major debacles at Societe Generale and Caisse d'Epargne, her arguments might be less than convincing. [With friends like that, who needs enemies?]
Regulators should realize that, like Monty Python's parrot, Basel II in its current form is not resting, but is dead, "He's not pining! He's passed on! He's a stiff! Bereft of life, He rests in peace! He's kicked the bucket, shuffled off this mortal coil!"
So is there anything to be salvaged from the vast amounts of time and money spent on Basel II? The answer has to be Yes, since there were many excellent concepts proposed in Basel II, if the whole eventually proved to be definitely a lot less than the parts.
Going forward, Basel regulation should be split into two distinct 'streams', lets call them 'Risk Governance' and 'Risk Capital' for now.
[The movie franchise use of roman numerals by Basel should also be dropped, let II be the last?]
Roughly Risk Governance should include what is in Pillars 2 and 3 of Basel II, plus a lot of other concepts, such as Risk Appetite and Reputation Risk, which were excluded from the original because they could not be easily quantified. On the other hand, Risk Capital would cover the calculation of capital needed to support an institution and is likely to be, for the foreseeable future, a mish mash of current Pillar 1 proposals plus a ragbag of other ideas such as a "counter-cyclical capital buffer".
[Note to regulators, reporting of risk is an integral part of Risk Governance and not an optional add-on, like Pillar 3 of Basel II.]
In Risk Governance, regulators should set the standards for how risk should be managed in firms of different sizes and industry sectors and they should set the bar very high. Having set exacting standards, regulators should then get out of the business of measuring compliance against those standards (a clear conflict of interest), leaving that instead to independent third parties, which for argument's sake let's call 'risk auditors'.
Likewise for Risk Capital, regulators should set the standards for calculating the capital to support an institution's risk taking and then leave the job of measuring compliance to independent third parties, let's call these 'financial auditors', since this is really an accounting function.
The link between these two 'streams' would be that any 'leverage ratios' used to relate risky assets to capital should be determined, at least in part, by the quality of a particular firm's risk governance.
Removing regulators from the messy business of measuring compliance with standards at individual institutions should then free them to be able to look across the industry at systemic risks and trends, which is their role after all? Regulators would of course have to maintain a small surveillance section to ensure that audits, risk and financial, are carried out correctly.
Having introduced another layer of audit, the 'risk auditor', the obvious question arises who would do it, apart that is from the Big Four accounting firms who could generate millions in fees? But other sources of expertise are available: rating agencies, once they work out their new role in the industry after the CDO fiasco; actuaries, who already do risk compliance work; and consulting firms, with appropriate certification of course.
In the light of the obvious failures of regulation, leading in part to the Global Financial Crisis, there are thousands of suggestions on how to go forward (admittedly including those above), but before the current proposals are thrown away, some analysis of what worked and what didn't may prove valuable.
For Basel's newly found detractors, Mark Antony's words in Shakespeare's' Julius Caesar may be timely:
"You all did love him once, not without cause:
What cause withholds you then to mourn for him?
O judgment! Thou art fled to brutish beasts,
and men have lost their reason"
Et II Brute?
