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Basel II Has Been a Basel II Has Been a Costly Distraction on the Costly Distraction on the Road to Minimizing the Road to Minimizing the Societal Cost of Bank Societal Cost of Bank

FailuresFailuresGeorge G. KaufmanGeorge G. Kaufman(Loyola University Chicago)(Loyola University Chicago)

For Presentation at FDICFor Presentation at FDICSeptember 13, 2006September 13, 2006

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Objectives of Public Policy Objectives of Public Policy Towards BankingTowards Banking

Safety – minimize adverse Safety – minimize adverse externalities of bank failures by externalities of bank failures by minimizing credit and liquidity lossesminimizing credit and liquidity losses

Efficiency – permit exit of inefficient Efficiency – permit exit of inefficient and/or unlucky banks without infecting and/or unlucky banks without infecting other banks and at minimal costother banks and at minimal cost

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Public Policy Provisions to Public Policy Provisions to Achieve ObjectivesAchieve Objectives

Framework to turn troubled banks around Framework to turn troubled banks around before failure --- PCA to supplement before failure --- PCA to supplement market disciplinemarket discipline

Mandatory legal closure rule at positive Mandatory legal closure rule at positive capital – regulatory insolvency (minimize capital – regulatory insolvency (minimize credit losses)credit losses)

Least cost resolution to insurance fund -- Least cost resolution to insurance fund -- loss-sharing with uninsured claimants loss-sharing with uninsured claimants (minimize moral hazard and maximize (minimize moral hazard and maximize moral discipline)moral discipline)

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Public Policy Provisions to Public Policy Provisions to Achieve Objectives (cont.)Achieve Objectives (cont.)

Speedy transfer of and access to Speedy transfer of and access to recovery value of assets and recovery value of assets and uninsured claims and par value of uninsured claims and par value of insured claims to other/bridge bank – insured claims to other/bridge bank – no physical closure (minimize liquidity no physical closure (minimize liquidity losses)losses)

Prompt reprivitization of bridge bank Prompt reprivitization of bridge bank at sustainable capitalat sustainable capital

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Requirements for Activating Requirements for Activating ProvisionsProvisions

Timely and accurate dataTimely and accurate data Useful measure of bank capitalUseful measure of bank capital Market discipline to supplement regulatory Market discipline to supplement regulatory

disciplinediscipline Credible provisions for enforcement of Credible provisions for enforcement of

required actions/sanctions, including legal required actions/sanctions, including legal closure, when capital ratios violated or closure, when capital ratios violated or threaten to be violated.threaten to be violated.

Public disclosure of how large banks will be Public disclosure of how large banks will be resolved – ex-ante rules of gameresolved – ex-ante rules of game

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Objectives of BaselsObjectives of Basels

Basel IBasel I• Obtain “useful” capital measure (risk-based)Obtain “useful” capital measure (risk-based)

Basel IIBasel II• Expand risk-based capital measure (Pillar 1)Expand risk-based capital measure (Pillar 1)• Include role for supervision (Pillar 2)Include role for supervision (Pillar 2)• Enumerate public disclosure items (Pillar 3)Enumerate public disclosure items (Pillar 3)

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BUTBUT Basel Provisions Fall Far Short of Satisfying Basel Provisions Fall Far Short of Satisfying Requirements for Minimizing Credit and Liquidity Requirements for Minimizing Credit and Liquidity

Losses and Achieving Financial StabilityLosses and Achieving Financial Stability

Pillar II – No mandatory supervisory actions, Pillar II – No mandatory supervisory actions, therefore only list of “best practices”. Does therefore only list of “best practices”. Does not prevent forbearance. No adjustment for not prevent forbearance. No adjustment for difference in quality of supervision across difference in quality of supervision across countries.countries.

Pillar III – No provision for strengthening “at-Pillar III – No provision for strengthening “at-risk” provisions of de-jure uninsured risk” provisions of de-jure uninsured claimants. Little impact on market discipline. claimants. Little impact on market discipline.

Pillar I – For public policy purpose. No Pillar I – For public policy purpose. No evidence that new capital measure evidence that new capital measure meaningful or better than simpler leverage meaningful or better than simpler leverage ratio. No mandatory “legal closure rule”. ratio. No mandatory “legal closure rule”. Increases opaqueness. Why?Increases opaqueness. Why?

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No Evidence Model-Based Risk No Evidence Model-Based Risk Capital MeaningfulCapital Meaningful

Recent quantitative impact studies of Basel II QIS4 in Recent quantitative impact studies of Basel II QIS4 in U.S. show strange and unacceptable results. U.S. show strange and unacceptable results. Perceived equally risky banks have greatly different Perceived equally risky banks have greatly different computed capital requirements and similar activities computed capital requirements and similar activities within banks have greatly different computed capital within banks have greatly different computed capital requirements across banks. Fat tails/no tails. requirements across banks. Fat tails/no tails. Complexity sufficient justification over simplicity and Complexity sufficient justification over simplicity and transparency? Some large banks now opposed. transparency? Some large banks now opposed.

For many large banks would lower regulatory capital For many large banks would lower regulatory capital requirement below 4% tier 1 leverage ratio that requirement below 4% tier 1 leverage ratio that defines “adequately capitalized.” Thus leverage defines “adequately capitalized.” Thus leverage ratio is constraint. Lobby to lower numerical trigger? ratio is constraint. Lobby to lower numerical trigger? Are banks overcapitalized now? Would lower capital Are banks overcapitalized now? Would lower capital help? help?

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Ranges of Minimum Required Capital (MRC) Ranges of Minimum Required Capital (MRC) Changes for Various Credit Portfolios As Indicated Changes for Various Credit Portfolios As Indicated

by QIS-4 Resultsby QIS-4 Results

Portfolio

Average %

Change in MRC

Largest %

Decline in MRC

Largest %

Increase in MRC

Corporate, Bank, Sovereign -22 -80 56 Small Business -27 -81 30 High-Volatility Commercial Real Estate -33 -60 110 Income-Producing Real Estate -41 -79 30

Aggregate Wholesale Credit -25 -80 56 Home Equity -74 -99 92 Residential Mortgage -61 -99 -18 Credit Card 66 -90 416 Other Consumer -7 -98 94 Retail Business -6 -100 204

Aggregate Retail Credit -26 -83 73 Equities 7 -94 78 Other Assets -12 -47 0 Securitization -18 -70 56

Change in Effective MRC -15 -47 56

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Range of Minimum Required Range of Minimum Required Capital (MRC) Changes for Capital (MRC) Changes for

Wholesale PortfoliosWholesale Portfolios

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Range of Minimum Required Range of Minimum Required Capital (MRC) Changes for Capital (MRC) Changes for

Retail Portfolios Retail Portfolios

draft 8/14/06draft 8/14/06 Source: FDIC, FYI: An Update on ESource: FDIC, FYI: An Update on Emerging Issues in Banking, p. 1 & merging Issues in Banking, p. 1 & BIS Annual Reports 2001-2003BIS Annual Reports 2001-2003

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Large Bank Capital Ratios and Large Bank Capital Ratios and Profitability by CountryProfitability by Country

Country Equity Capital ÷ Total Assets

Pre-Tax Profits ÷ Total Assets

2002 2002 2000-02 (Percent)

United States 6.34 1.66 1.67

Spain 5.07 0.93 1.15

Australia 4.91 1.49 1.61

Italy 4.68 0.48 0.81

United Kingdom 4.49 1.11 1.34

Canada 7.32 0.61 0.93

France 3.94 0.58 0.72

Japan 3.15 0.04 -0.25

Germany 2.63 0.05 0.29

Switzerland 2.18 0.08 0.49

draft 8/14/06draft 8/14/06 Source: Banker Magazine, July 200Source: Banker Magazine, July 20055

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Top 100 Capitalized Banks in the World, Top 100 Capitalized Banks in the World, 2004 by Geographic Region and Share of 2004 by Geographic Region and Share of Total Assets, Tier 1 Capital, and Pretax Total Assets, Tier 1 Capital, and Pretax

ProfitsProfits

Region Total Assets Tier 1 Capital Pretax Profits (Percent of Total) United States 15 23 30 European Union 56 51 47 Japan 13 11 6 Rest of Asia 5 6 4 Rest of Europe 6 3 5 Rest of World 5 6 8

Total 100 100 100

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Cost of Basel II ExerciseCost of Basel II Exercise

Focus primarily on 1 issue – “better” measure Focus primarily on 1 issue – “better” measure of bank capital – with at best mixed results. of bank capital – with at best mixed results. More recent refinements “exercises in More recent refinements “exercises in minutia”. Absorbs way out of proportion minutia”. Absorbs way out of proportion highly skilled manpower and financial highly skilled manpower and financial resources.resources.

Takes eye of real issue – improving stability of Takes eye of real issue – improving stability of the banking/financial system. More than the banking/financial system. More than measure of capital and good intentions. measure of capital and good intentions. Comprehensive plan, e.g., US style SEIR Comprehensive plan, e.g., US style SEIR superior structure for public policy.superior structure for public policy.

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Resources Better Used Resources Better Used ElsewhereElsewhere

In U.S., designing and simulating large (TBTF) bank In U.S., designing and simulating large (TBTF) bank resolution process and publicly disclosing plan, issue resolution process and publicly disclosing plan, issue financial stability report, join IMF-WB Financial Sector financial stability report, join IMF-WB Financial Sector Assessment Program (FSAP)Assessment Program (FSAP)

In other countries, developing legal closure rule and PCA In other countries, developing legal closure rule and PCA similar to U.S. and legal prerequisites (separate bank similar to U.S. and legal prerequisites (separate bank bankruptcy code). Enhance availability of timely and bankruptcy code). Enhance availability of timely and accurate data. Improve quality of supervision.accurate data. Improve quality of supervision.

In EU, preparing appropriate deposit insurance and closure In EU, preparing appropriate deposit insurance and closure rule provisions for single license cross-border branching in rule provisions for single license cross-border branching in light of confusion from multiple insurance systems in light of confusion from multiple insurance systems in country and home-host country conflicts from home country and home-host country conflicts from home country responsibility for deposit insurance and closure of country responsibility for deposit insurance and closure of branches in host countries. No single deposit insurance branches in host countries. No single deposit insurance agency or bankruptcy code. Need to deal with “dark side” agency or bankruptcy code. Need to deal with “dark side” of cross-border banking. Otherwise cross-border branching of cross-border banking. Otherwise cross-border branching may not occur.may not occur.

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ConclusionsConclusions Basel II has taken eye of major public policy Basel II has taken eye of major public policy

objectiveobjective Basel II has absorbed massive resources that Basel II has absorbed massive resources that

could have been put to better use. Badly fails could have been put to better use. Badly fails cost-benefit test.cost-benefit test.

Most countries appear little, if any, better off in Most countries appear little, if any, better off in reducing costs of banks crises than at beginning reducing costs of banks crises than at beginning of Basel II.of Basel II.

Thus, high opportunity cost.Thus, high opportunity cost. Should quickly redirect resources to broader Should quickly redirect resources to broader

public policy objectives of elimination adverse public policy objectives of elimination adverse externalities of bank failures. Curtail Basel II externalities of bank failures. Curtail Basel II refinements. refinements.

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““Those that cannot remember the past are Those that cannot remember the past are condemned to repeat it”.condemned to repeat it”.

--George Santayana (1905)--George Santayana (1905)

Remember Remember ignore, forgetignore, forgetCondemnedCondemned doomeddoomedRepeatRepeat reliverelive

But what do those who remember the past do?But what do those who remember the past do?““Those that remember the past, agonize first and Those that remember the past, agonize first and then repeat it”then repeat it”

--George G. Kaufman--George G. Kaufman

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Paraphrasing President Ronald ReaganParaphrasing President Ronald Reagan

““Mr. Basel, let those resources go.”Mr. Basel, let those resources go.”