The Lesson of Basel's Bean Counters

Decades of obsession with accounting standards couldn't overcome the perverse incentives created by 'too big to fail.'

By GEORGE MELLOAN

With all this attention to banking regulation, it seems strange that something called Basel III has escaped widespread notice, even though its various new rules have been up for public discussion since January and the window closed on that opportunity on Friday, April 16. Maybe it's because the Basel Accords, a set of rules agreed to by bank regulators around the world, have been something of an embarrassment to the authors.

Basel I was fashioned in the charming old Swiss city of that name in 1988 by banking regulators from the International Monetary Fund's Group of 20 leading industrial nations. The idea was to give an increasingly globalized financial-services industry a common set of rules so that bankers could have more confidence in the solidity of their global counterparties.

The main achievement of Basel I was to set risk-based capital standards for banks. A complex formula was devised to define what value could be given various forms of capital outside "core" forms such as common stock and reserves.

The designers also tackled the more challenging task of assigning degrees of risk to a wide range of potential bank investments. In an unsurprisingly generous gesture toward national treasuries, banks were allowed to regard government-issued securities as zero risk, meaning they would require no offsetting capital. Since expanding capital is expensive, banks had a new incentive to buy government bonds.

But while this was a noble effort at international regulatory coordination—and was in fact folded into the regulatory systems of the major industrial powers—it didn't do much to ensure bank safety. Japanese banks were boasting that they were over-compliant with Basel standards right before they tanked in 1990. It seems that some of their "capital" was marked-to-market Japanese stocks and a lot of their risks were in real estate. When both stocks and real estate collapsed as a result of the decision by the Bank of Japan to prick the credit bubble, the Basel standards might just as well have not existed.

So the Basel Accord drafters went back to the drawing board and came up with Basel II, which some member states have adopted over the last few years. The standards were toughened and broadened in an attempt to take account of the changes in banking, especially increased trading in securities and derivatives. But the Basel standards proved to be largely irrelevant to the factors that caused the fall 2008 near-meltdown of global finance. For example, Lehman Brothers had close to triple the core capital required by the Basel standards when it crashed.

The international banking tumult of 2008 was not a result of insufficient rules or even primarily of noncompliance with the rules. Banking is perhaps the world's most regulated major industry. As in Japan in 1990, the imperatives of politics simply overrode what the rule makers and rule enforcers were trying to accomplish, turning their labors to dust.

The 2008 crisis resulted when the Fed-created credit bubble collapsed and soaring housing prices deflated as well. To promote "affordable" housing, Bill Clinton had excused the two giant government-sponsored housing finance agencies, Fannie Mae and Freddie Mac, from normal banking rules, allowing them leverage ratios far in excess of the limits on ordinary lenders. Banks were forced to write risky mortgage loans, a large number of which were then folded into mortgage-backed securities that Fannie, Freddie and others sold internationally with triple-A ratings.

This business seized up, crippling banks throughout the world, when holders began to realize that the assets that backed the securities, home mortgages, were going under water at an alarming rate. One of the great ironies of our times is that the two strongest defenders of the Fannie-Freddie shell game, Chris Dodd and Barney Frank, are now in charge of reforming banking regulation.

Through all this the Basel Accord designers have been soldiering on, this time coming up with Basel III, which further tightens and broadens risk-based capital rules. This new effort to raise the cost of banking is not going down well with bankers and even some central banks. At any rate, implementation is years off at best and the main state of play at the moment is the Dodd bill.

Aside from giving Washington an even tighter grip on the banking industry, the Dodd bill partly institutionalizes what Ben Bernanke at the Fed, Henry Paulson at Treasury, and Timothy Geithner at the New York Fed did ad hoc in the fall of 2008. It permits backdoor bailouts and gives enormous additional powers to the same Fed that created the housing bubble.

Like the Basel Accords, it assumes that the bank regulators will some day get things right before the industry wrecks itself by depending too much on rule compliance and not enough on sound banking judgment. Even a 1,336 page bill is not sufficient to guide the government in its endeavors to micromanage banking, as the prodigious efforts of the Basel committee have demonstrated.

An assessment of Basel III is provided on the Web site of a London based organization called the Asymmetric Threats Contingency Alliance (ATCA), which came into being in 2001 to promote online discussion of global issues. It concludes, quite plausibly, that "Despite promises that regulators will be vigilant and central bankers more watchful, banks are certain to get into trouble again, as they always have throughout history. The way to protect taxpayers, the Basel III argument goes, is to compel banks to have buffers thick enough to withstand higher losses and longer periods of extreme volatility in financial markets before they call for government intervention."

As the ATCA paper notes, in the days before banks could rely on governments to save them they carried large capital buffers, with core capital sometimes as much as 15% to 25% of assets, as opposed to as little as 2% under current rule. Of course, that made banking more expensive, and bankers were choosier about risks than in today's world, where the U.S. government has chosen to treat some banks as worthy of taxpayer help because they are "too big to fail."

One thing seems certain, the promise of bailouts and better regulation is unlikely to restore better risk judgment to the profession of banking. The opposite is more likely.

Mr. Melloan, a former columnist and deputy editor of the Journal editorial page, is author of "The Great Money Binge: Spending Our Way to Socialism" (Simon & Schuster, 2009).

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