As the world haltingly recovers from the recession, regulators are struggling to modify the financial system to prevent another crisis. The latest effort: stricter capital requirements to help prevent large banks from collapsing under the weight of unexpected losses.

The new proposals — called Basel III for the organization that coordinated the negotiations, the Basel Committee on Banking Supervision — are designed to reduce risk-taking by increasing a key capital requirement to 7% of assets from the previous 2% international standard and the 4% used by large U.S. banks. But the committee, worried that discouraging banks’ willingness to lend would slow the recovery, recommended phasing in the rules over eight years. While many experts say the proposals move in the right direction, some critics say the rules are too weak and too slow to take effect.

“I’m not impressed with its rigor,” says Wharton finance professor Richard J. Herring, arguing that such rules would have done little to prevent the bank failures that required government bailouts in 2008 and 2009. “It still doesn’t require as much equity capital as all the major banks that required intervention had in the reporting period before they failed. And the lengthy phase-in period means it will only get weaker before it’s actually put in place.”

According to Wharton finance professor Franklin Allen, the proposed rules would improve bank safety somewhat, but he worries that regulators have focused on narrow issues without adequate study of the more complex interactions between banking, the financial markets and the world economy. “It’s not clear exactly what the problem they are solving is,” Allen says.

Basel III is meant to assure that banks have enough capital on hand to continue lending in a weak economy, and to avoid the kind of crisis that shook banks in recent years. Raising capital requirements should discourage banks from making some of the risky bets involved in the financial crisis, but in doing so could crimp profits. Banks have warned that tightening the rules too much could restrict lending and raise borrowing costs.

Although the term Basel III has become common, the committee itself does not use it, and most experts agree the new rules are a refinement of earlier rules rather than the kind of broad regulatory reform attempted in Basel I and II. Basil I set minimal bank-capital requirements in 1988, and a more elaborate set of standards was set in 2004 under Basel II. “It isn’t as revolutionary is it may appear,” Herring says of Basel III. “It is, in a way, tidying up unfinished business from Basel II.”

Assuring Adequate Liquidity

The Basel Committee, which meets in Switzerland, coordinated talks among 27 countries and announced the proposals September 12. The proposals will be presented to the Group of 20 leading nations when they meet in South Korea in November. If that group approves, it will be up to each nation to adopt its own rules.

The newest proposals were supported by top regulators in the United States, including Treasury Secretary Timothy Geithner and Federal Reserve chairman Ben Bernanke, although they had wanted faster implementation. Some European and Asian countries pushed for a slower phase-in, arguing a fast pace would slow the recovery and that they should not be penalized for a crisis that arose in the U.S. According to most reports, while U.S. banks generally have enough capital to satisfy the requirements for some time, they might eventually have to increase their capital if the new rules are approved.

But Basel III leaves a number of questions unanswered, such as what to do about banks considered too big to fail, and how to assure that banks have enough liquidity to fund day-to-day operations. Basel III would require banks to hold common equity equal to the value of 4.5% of their assets by the start of 2015, up from today’s 2%. Common equity, thought to be the least risky form of equity, generally means the amount of money investors have invested in a company’s stock, plus retained earnings, or profits not paid out in dividends. By 2019, banks would also be required to have a 2.5% capital conservation buffer of common equity to draw on in tough times. Together, those requirements lift the common equity ratio from 2% to 7%.

In addition, the Basel Committee recommended that national regulators enact rules allowing them to impose a “counter-cyclical buffer” of up to 2.5% percent of assets. That would be composed of assets like common stock, to be built up in good times and drawn down in bad ones.

A bank that falls below the Basel III thresholds could be required to retain more earnings, leaving less money for dividends and executive pay. Press coverage indicates most banks already meet the new requirements, but the proposed rules would deter them from reducing capital as they hunt profits in the future. Bank stocks jumped when the rules were announced, indicating investors were happy the industry could easily meet the requirements and had averted stricter ones.

Herring, a member of the Shadow Financial Regulatory Committee sponsored by the American Enterprise Institute, sees a number of shortcomings in Basel III, starting with the low capital requirement and lengthy phase-in period. In some respects, the Basel III capital requirement would simply restore earlier requirements that have eroded over the years as banks lobbied for loopholes and exploited them, he says.

The Basel Committee also has yet to set restrictions on leverage, or the amount an institution can borrow relative to its assets, he adds. More leverage causes greater risk. “Moreover, it’s done nothing to corral the ‘shadow banking system’ that isn’t bank based,” he notes, referring to non-bank institutions such as hedge funds, pension funds, money market funds and insurance companies that have bank-like activities, such as making loans, which influence the amount of risk in the system.

The shadow committee’s statement on Basel III also complains that “the recommendations continue to rely heavily upon a flawed risk-based capital model that employs arbitrary risk weights, banks’ own risk models and book value concepts that proved to be inadequate as indicators of financial strength during the recent crisis.” In other words, the banks have much influence over the data that indicates whether they are taking too much risk.

The capital-conservation and counter-cyclical buffers are “insufficient to protect against sudden shocks,” the shadow committee says, adding that enforcement provisions look too lenient. Basel III requires cutbacks on earnings distributions such as dividends, rather than prohibiting them entirely when key thresholds are reached. “Permitting a payout of capital when a firm’s capital cushion is declining toward a critical threshold makes little economic sense,” the statement adds.

It would be easier to contain risks by imposing limits on borrowing than to use capital requirements, the committee suggests. Finally, it criticizes the long phase-in period, arguing that one to two years would be enough.

Eliminating the Interest Deduction

According to Allen, preventing a repeat of the financial crisis requires much more than the Basel III reforms. Moral hazard, or the tendency to take risks in hopes of government bailouts if things go wrong, is still a problem.

He also worries that Basel III focuses on accounting data rather than information culled from the financial markets, which can indicate whether investors think a bank is getting too risky. In common equity calculations, stock is generally valued at its original issue price rather than its current market price, which better reflects the institution’s health, Allen says. “Wachovia’s regulatory capital was fine the day it went under, but the markets didn’t trust it,” he recalls, referring to the troubled bank that was taken over by Wells Fargo at the end of 2008.

A broader look at how regulations influence financial institutions’ behavior would also account for the different treatment of the two chief ways companies raise money, by issuing stock or borrowing, Allen notes. Tax laws encourage taking on debt by making interest payments deductible, while there is no comparable deduction for issuing stock. If the interest deduction were eliminated, companies would be more likely to issue stock to raise money, reducing the risk that accompanies indebtedness, Allen argues. “There’s no good justification for having interest deductibility.”

Moreover, if capital requirements were increased to 15% or 20%, and focused on equity capital, putting shareholders’ money at more direct risk, companies would have a bigger incentive to play it safe, Allen says. “For society, why is it costly to ask for 20% equity buffers?” he asks. “This is the heart of the debate, but [regulatory bodies] don’t really think about those things.”

Mark Zandi, chief economist and cofounder of what is now Moody’s, believes the Basel III standards are “roughly right. Higher capital standards and stiffer liquidity requirements are necessary, and I think Basel III gets us a long way toward where we need to be,” he says, suggesting that tightening regulations too much can inhibit lending. “It’s a very difficult balance to get right.”

He notes that Basel III remains a work in progress, with key issues still to be resolved, such as how to stiffen requirements when the lending seems to be growing too fast, as it was during the easy-credit years building up to the financial crisis. “Historically, if there’s a lot of credit growth today, there are a lot more credit problems in the future.”

Would the recent financial crisis have been less severe, or averted, if the Basel III rules had been in effect years ago? “It would have been less severe,” Zandi says. “I don’t know that we would have avoided it…. The fundamental reasons for our problems were so overwhelming and massive that even if you had a perfectly capitalized financial system, I think we still would have had a problem.”