Basel 3 quick fix is neither

Critics find little assurance that proposed standards will prevent banking failures.

Remember the implosion of Lehman Bros. in 2008 when, across the planet, bank foundations wobbled? No major Canadian institutions toppled, but sector stocks were hammered as national governments collectively spent trillions to save the financial system from itself.

Now, two years later, the Basel Committee on Banking Supervision has recommended fixes intended to prevent another failure. If adopted, the so-called Basel 3 standards will force banks to hold top-quality capital totalling at least 7% of their risk-bearing assets. New rules aimed at reducing risks associated with counterparty transactions and introducing liquidity stress tests have also been drafted.

Supporters insist a good balance has been struck between improving the Basel 2 framework (which essentially ignored liquidity) and maintaining enough lending capacity to fuel a global economic recovery. And judging by the way bank shares jumped after the new rules were released, many investors agree.

Many, but not all. In fact, a number of critics say the Basel 3 measures fall far short of what’s required to stop banks from doing another domino impression — and that renewed confidence in the system is unwarranted.

Take Wesley Gill, a risk management executive with SAS Canada, who helped draft Basel 2 as a banking executive. He likes the move toward addressing liquidity issues, but is not sure Basel 3 has gone far enough — or if it will even be followed. Keep in mind, he says, the proposals are just non-binding recommendations to national regulators.

Mark Williams, a Boston University management professor and author of Uncontrolled Risk: Lessons of Lehman Brothers and How Systemic Risk Can Still Bring Down the World Financial System, says Basel 3 is irrelevant because it will take nine years to roll out. And as far as he is concerned, banking needs to be made boring again by turning back the clock to the days when casino-like activities were separated from the retail system that holds consumer savings.

Ari Axelrod, a research fellow at Tufts University’s Fletcher School, also sees merit in separating investment banking from retail operations. But that’s not on the table. Meanwhile, Axelrod points out that Basel 3 could actually generate a false sense of security because few people realize it introduces no changes whatsoever for two years. And “when people talk about a possible European nation debt default, we’re talking about something that could happen within 12 to 18 months fairly easily.”

Furthermore, the Tufts fellow thinks banks that wisely beefed up capital reserves expecting to be held to a higher standard will now “feel tempted” to reduce existing safety nets. But his big concern is that high-risk government debt can still be carried on the books as safe capital. “By the time Basel 3 is fully rolled out,” he says, “who knows who will be the sick man of the financial system. It could be the U.K., France, or even the United States. And I cannot believe capital levels of 7%, or even 15%, will make a difference if one of those defaults.”

Axelrod insists the financial system will eventually face another major crisis, and that none of the changes he has seen will prevent another major bank from failing if a big one hits.

He isn’t just speaking as an academic. Prior to joining Tufts in 2008, Axelrod was head of capital management at Lehman — where he says his experience was “like driving a car at 85 miles per hour, knowing that’s probably too fast, but not fully appreciating the danger.”