Hooray! Basel III is Working Pretty Well So Far

After the great crash of 2008, two big new financial regulations were put in place. In the U.S., Congress passed the Dodd-Frank Act. Internationally, the Basel III accord increased the amount of capital that banks are required to hold. Of the two, Basel III is probably the more important, but only if it actually works as planned. So has it?

Via Matt Levine, Felix Salmon glosses a new BIS report today and concludes that, basically, yes, so far it’s worked pretty well. Banks all yelled and screamed that higher capital requirements would destroy their lending business, but it hasn’t. Nor have banks really had much trouble meeting the new capital standards. In fact, they’ve met them well ahead of schedule:

The banks achieved this feat in the most painless way possible: they simply retained their earnings, rather than paying them out in dividends. And those earnings weren’t easy to come by, either. The banks in general shed what Levine calls “income that lots of people find naughty, prop trading and so forth”, which reduced their overall profitability. The banks instead had to make money the old-fashioned way, by lending it out at a higher rate than their cost of funds. Net interest income, across all global banks, rose substantially from the pre-crisis period to the post-crisis period: it was 1.34% of assets in 2005-7, and 1.62% of assets in 2010-12.

As it happens, U.S. bank lending still hasn’t returned to pre-crash levels—though it’s been growing nicely for the past couple of years. But I’m with Felix that this is OK:

I’m not sure that this [] is really bad news. If you stipulate that there was too much lending in the economy in 2008, and that we needed to enter a period of slow deleveraging, this is actually exactly what the doctor ordered.

….And in reality, a large part of the stagnation in bank lending has to be a consequence of the fact that the economy as a whole is evincing little demand for credit. Individuals are more interested in paying down their debts than they are in borrowing more; businesses, too, have learned the hard way that debt has a tendency to bite, hard, at the worst possible moment….So I’m with Levine on this one: so far at least, Basel III seems to be working in an almost optimal manner. We’re used to a world where the only way you can achieve growth is through leverage — and we learned, with extreme pain, that leverage is a very dangerous thing. This recovery, by contrast, is not being driven by leverage. And that is surely a good thing.

Yep. The big question is whether this is just a short-term reaction to a traumatic financial crisis or whether it’s a lesson that stays learned for a while. I have a fundamentally Minsky-ite view that this lesson will be unlearned within a few years as fears fade and everyone makes up clever new reasons to believe that new economic paradigms make leverage safer than in the past, so the big question is whether regulators have longer memories and will stick to their guns if they see leverage increasing dangerously.

We’ll know in a few years. In the meantime, you should be unsurprised to learn that all the caterwauling from banks about Basel III’s new capital requirements was, as usual, just the usual self-interested rubbish. They’ve met the new standards; they’ve met them sooner than expected; they’ve stayed profitable doing so; and lending is in perfectly good shape. That’s good news all around.


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