International bank regulators are attempting the gargantuan task of coordinating global banking rules that could short-circuit some systemic financial crises before they take hold. In a sweeping new rule that got little attention when approved in December, regulators under Basel III set up an early warning system hoping to spot credit bubbles before they grow too large and then apply automatic, offsetting measures.
In practice, it means regulators will now try to identify key credit spikes thought to signal the emergence of a credit bubble within a single country that could spread to partner countries. Once one country is found overheating, its home banks will have to raise critical reserves – measured as the “tier one” capital reserve ratio – by as much as 2.5 percentage points (on top of the recently approved 7% minimum tier-one ratio requirement). Such action is meant to squelch credit availability and deflate any fledgling credit bubble.
Even more significant: The plan requires banks based in cooperating countries to force their branches in the bubble-creating country to raise tier-one capital reserves by a percentage that would vary according to how much business a branch generates there.
This measure goes much further than earlier attempts to coordinate credit-bubble management. Regulators floated a milder version of this idea at the recent Seoul G-20 meeting, notes Richard J. Herring, a Wharton professor of international banking and co-director of the Wharton Financial Institutions Center. “I gave it very little attention because it was to be a Pillar 2 exercise [governed by Basel II rules affecting risk management and capital adequacy] and therefore cloaked in secrecy,” he added. That version was also to be undertaken “at the discretion of the home supervisory authority.”
But, “what is strikingly new about the revised proposal is the commitment from other central banks to join in raising capital requirements for their banks’ activities in the country that believes it is entering a bubble.”
Is such cross-border regulatory integration likely to work?
Herring doubts it, though he is impressed with the degree of cooperation it took to get this far. He notes that, as many experts point out, it is very difficult to identify a bubble before it happens, largely because it is “extraordinarily difficult to distinguish between improving fundamentals and a nascent bubble.” What’s more, it takes a very “courageous supervisor to pull the rip cord. Recall the profound reluctance the Fed expressed in the face of strong evidence of a housing bubble.”
Then there is the danger of unintended consequences. “Our knowledge of the transmission mechanism, from an increase in capital requirements to the impact on the real economy, is not so precise that we can be sure that the impact will not be perverse,” Herring points out. “It’s an important problem, but I’m not sure that we have solution that yields an improvement in outcomes.” Herring is also co-chair of the Shadow Financial Regulatory Committee, part of the American Enterprise Institute.