Basel III will help fix the Euro

The Basel III compromise is out.  Via Free Exchange, you can read the text here.  Or you can just look at the BIS’s handy-dandy little chart:

Let me quote Ryan at Free Exchange:

The minimum common equity requirement has been increased from 2% to 4.5%. Common equilty is what is called “core” Tier 1 capital. Regulators have agreed on an additional 2.5% “conservation buffer”. Most large banks will likely maintain such a buffer, as falling below it will lead to additional regulatory scrutiny. The likely impact, then, is a pretty substantial increase in the common equity reserves banks need to hold.

What he said. Anyway …

The asterisk on the countercyclical buffer has this note against it: “Common equity or other fully loss absorbing capital”.  Here’s some more detail, from the press release itself:

A countercyclical buffer within a range of 0% – 2.5% of common equity or other fully loss absorbing capital will be implemented according to national circumstances. The purpose of the countercyclical buffer is to achieve the broader macroprudential goal of protecting the banking sector from periods of excess aggregate credit growth. For any given country, this buffer will only be in effect when there is excess credit growth that is resulting in a system wide build up of risk. The countercyclical buffer, when in effect, would be introduced as an extension of the conservation buffer range.

In other words, the countercyclical buffer is expressly designed to allow for different rates of credit expansion across different countries.  This is excellent news for the Euro area, because (as I mentioned previously) it explicitly allows — heck, even encourages! — individual member countries to re-assert some control over monetary policy.  Remember that the level of credit in an economy is not just affected by demand for the stuff (which is itself influenced largely through interest rates), but also through the supply of the stuff, which falls under the umbrella of macro-prudential regulation (since, it is assumed, banks will generally supply all the credit they can subject to the restrictions of capital adequacy regulations).  The former may remain the remit of the ECB, but the latter can be economy-specific.

This is arguably desirable because, since the Euro-area economies are not perfectly synchronised, we have for many years seen monetary policy be overly tight for low-inflation countries like Germany and overly lax for high-inflation countries like Spain.

To some extent, one might view Germany’s reluctance to accept tighter capital requirements as evidence that they have been tacitly using this logic all along:  that is, they were already compensating for the (to them) overly-high interest rate with relatively lenient policies on the supply side.  To a German’s mind, it may therefore appear that with these higher minimum ratios, a neutral position for the German economy will require lower interest rates on average than previously prevailed.

The risk, from the Germans’ point of view, is that in a Eurozone world with higher capital ratios but lower interest rates, countries like Spain may be tempted to avoid making use of the countercyclical buffer and so may still end up with faster-than-ideal credit expansion.  How to convince the central banks and/or regulatory authorities in Mediterranean countries to be financially conservative, even when their governments aren’t, is clearly the next challenge.

3 Responses to “Basel III will help fix the Euro”

  • I do like the idea of the counter-cyclical fund. One of the big problems with Basel I+II was the pro-cyclical of marking to market.

    How does it work though? National regulators or central banks make a call to start jacking up counter-cyclical requirements, much as they do interest rates? I guess particular central banks could also choose to tie it to a particular passive instrument, eg VIX.

    It reminds me (in reverse) of the mechanism China used for stimulus – phoning up all their banks and telling them to jack lending up. Since changing interest rates or repegging the yuan were options off the table.

  • Well, increasing interest rates and increasing the countercyclical buffer requirement should have at least somewhat different effects on the economy: Raising the countercyclical buffer should only affect the creation of new credit, but raising the interest rate will also affect any existing credit arrangement without a fixed interest rate.

    I’m not sure, but I suspect that most business borrowing is on fixed-rate terms while, outside of America, at least (where it’s common to have mortgages with a rate fixed for the entire life of the mortgage), consumer borrowing is commonly on non-fixed-rate terms.

  • I was a bit unclear in the original comment. I mean, organizationally, that the fact the central banks wield the power is similar to interest rates, not that the effect of interest rate rises and capital requirement changes are identical.

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