Robert Jenkins: Basel II proved to be inadequate, so are the new rules really 'too severe'?

The pre-crisis Basel rules required less than 1 per cent of loss-absorbing capability for a mortgage with no money down

Do you think the pending changes in bank regulation are sufficient, insufficient or excessive? Banks take risks. When more risks go right than go wrong, the result is a profit. At other times a bank's equity capital absorbs the losses. If there is not enough capital there is one less bank – or one more call to the taxpayer.

Of course some risks are riskier than others. It follows that one should have more capital to support the riskier activities and less for the less risky. This in a nutshell is the basis for the Basel rules governing global banking. Sounds sensible? So how much capital should a bank have to support a given level of risk?

Take foreign government bonds. Do you think they are risky, very risky, or safe as houses?

You answered correctly: some are and some aren't. Greece is riskier than Germany, nicht wahr? So would you expect a bank to have equity capital available to absorb losses from its investment in sovereign debt? Yes? The Basel committee of the day did not think so. No capital was required for what was judged to be an asset without risk. Bad call: the writedown on Greek bonds was 74 per cent.

Now let us take a look at mortgage lending. Many of us own a house, or wish to. Do house prices always go up? No. Might they sometimes go down? Yes. How much might they go down: 5, 10, 15 per cent, or all of the above?

"All of the above" would be a reasonable reply. So, what level of loss did the pre-bust Basel rules implicitly assume? More simply, how much loss-absorbing equity do you think the banks had to have to support a loan for 100 per cent of the purchase price of a house? £5 per £100? £10 per £100? Answer: 86 pence for every £100 of loan. In other words, the Basel regulations required less than 1 per cent of loss-absorbing capability for a mortgage with no money down.

Of course, straight mortgage lending is not the sexy stuff for many financial giants. Some investment bankers made millions by originating and distributing an alphabet soup of securitisations. Remember CDOs squared? How much loss-absorbing capital do you think the old Basel rules required of banks to carry an investment in a debt obligation backed by a debt obligation backed by a pool of loans made to US sub-prime residential home owners? (No, that was not a misprint.) Oh, and assume that these easy-to-understand securities were rated AAA by the world's leading credit rating agencies. What could possibly go wrong? Well, not much, in the judgement of the day. Basel required banks to have 40p per £100 of such stuff. Many banks thought this was far too conservative and convinced the regulators that their "advanced" risk management systems warranted a reduction to 14p per £100. The ensuing losses proved somewhat in excess of that.

Of course that was then and this is now. We've all learned from our mistakes, right? Judging from the reaction of the banking lobby, you would say yes. "Onerous", "tough" and even "unreasonably severe" lace the language of regulatory pushback. Yet for your info, the new rules (the new improved version of Basel II, which was in turn the new improved version of Basel I) demand £1.35 of equity capital in support of every £100 of similarly rated CDOs squared – a loss-absorbing capability of less than 1.4 per cent for a risk which most rating agencies, regulators, bankers and investors have already misjudged.

Is it surprising that some regulators – such as the Swiss – have signalled their intention to go beyond the new Basel minimum?

Capital is there to absorb losses from risks we understand and risks we may not understand. Evidence suggests that neither risk-takers nor their regulators fully understand the risks that banks sometimes take. That's why banks need an appropriate level of loss-absorbing equity. Will the new Basel levels be enough? Time will tell. But if we are to err at all, surely it should be on the side of too much rather than too little capital. Many bankers believe they know better. But is that the way to bet?

Robert Jenkins is Adjunct Professor of Finance at London Business School and an external member of the Financial Policy Committee of the Bank of England. He writes in a private capacity

PROMOTED VIDEO
News
Actor, model and now record breaker: Jiff the Pomeranian
Video
News
Down time: an employee of Google uses the slide to get to the canteen
businessHow bosses are inventing unusual ways of making us work harder
News
REX/Eye Candy
science
News
i100
Sport
Alexis Sanchez celebrates after scoring his first goal for Arsenal in the Champions League qualifier against Besiktas
sportChilean's first goal for the club secures place in draw for Champions League group stages
Arts and Entertainment
Amis: 'The racial situation in the US is as bad as it’s been since the Civil War'
booksAuthor says he might come back across Atlantic after all
Extras
indybest
News
ebooksAn evocation of the conflict through the eyes of those who lived through it
Life and Style
Google Doodle celebrates the 200th birthday of Irish writer Sheridan Le Fanu
tech
Arts and Entertainment
Vinyl demand: a factory making the old-style discs
musicManufacturers are struggling to keep up with the resurgence in vinyl
News
i100
News
In Eternal Sunshine of the Spotless Mind Jim Carrey and Kate Winslett medically erase each other from their memories
scienceTechnique successfully used to ‘reverse’ bad memories in rodents could be used on trauma victims
Arts and Entertainment
Singer Pixie Lott will take part in Strictly Come Dancing 2014, the BBC has confirmed
tv
Latest stories from i100
Have you tried new the Independent Digital Edition apps?
Independent Dating
and  

By clicking 'Search' you
are agreeing to our
Terms of Use.

iJobs Job Widget
iJobs Money & Business

C# Developer (C#, ASP.NET Developer, SQL, MVC, WPF, Real-Time F

£40000 - £48000 per annum + benefits+bonus+package: Harrington Starr: C# Devel...

C# Swift Payment Developer (C#, ASP.NET, .NET, MVC, Authorize.N

£45000 - £60000 per annum + benefits+bonus+package: Harrington Starr: C# Swift...

DevOps Engineer - Linux, Shell, Bash, Solaris, UNIX, Salt-Stack

Negotiable: Harrington Starr: A fast growing Financial Services organisation b...

Trade Desk FIX Analyst - (FIX, SQL, Equities, Support)

£50000 - £60000 per annum + excellent benefits: Harrington Starr: An award-win...

Day In a Page

Israel-Gaza conflict: No victory for Israel despite weeks of death and devastation

Robert Fisk: No victory for Israel despite weeks of devastation

Palestinians have won: they are still in Gaza, and Hamas is still there
Mary Beard writes character reference for Twitter troll who called her a 'slut'

Unlikely friends: Mary Beard and the troll who called her a ‘filthy old slut’

The Cambridge University classicist even wrote the student a character reference
America’s new apartheid: Prosperous white districts are choosing to break away from black cities and go it alone

America’s new apartheid

Prosperous white districts are choosing to break away from black cities and go it alone
Amazon is buying Twitch for £600m - but why do people want to watch others playing Xbox?

What is the appeal of Twitch?

Amazon is buying the video-game-themed online streaming site for £600m - but why do people want to watch others playing Xbox?
Tip-tapping typewriters, ripe pongs and slides in the office: Bosses are inventing surprising ways of making us work harder

How bosses are making us work harder

As it is revealed that one newspaper office pumps out the sound of typewriters to increase productivity, Gillian Orr explores the other devices designed to motivate staff
Manufacturers are struggling to keep up with the resurgence in vinyl records

Hard pressed: Resurgence in vinyl records

As the resurgence in vinyl records continues, manufacturers and their outdated machinery are struggling to keep up with the demand
Tony Jordan: 'I turned down the chance to research Charles Dickens for a TV series nine times ... then I found a kindred spirit'

A tale of two writers

Offered the chance to research Charles Dickens for a TV series, Tony Jordan turned it down. Nine times. The man behind EastEnders and Life on Mars didn’t feel right for the job. Finally, he gave in - and found an unexpected kindred spirit
Could a later start to the school day be the most useful educational reform of all?

Should pupils get a lie in?

Doctors want a later start to the school day so that pupils can sleep later. Not because teenagers are lazy, explains Simon Usborne - it's all down to their circadian rhythms
Prepare for Jewish jokes – as Jewish comedians get their own festival

Prepare for Jewish jokes...

... as Jewish comedians get their own festival
SJ Watson: 'I still can't quite believe that Before I Go to Sleep started in my head'

A dream come true for SJ Watson

Watson was working part time in the NHS when his debut novel, Before I Go to Sleep, became a bestseller. Now it's a Hollywood movie, too. Here he recalls the whirlwind journey from children’s ward to A-list film set
10 best cycling bags for commuters

10 best cycling bags for commuters

Gear up for next week’s National Cycle to Work day with one of these practical backpacks and messenger bags
Paul Scholes: Three at the back isn’t working yet but given time I’m hopeful Louis van Gaal can rebuild Manchester United

Paul Scholes column

Three at the back isn’t working yet but given time I’m hopeful Louis van Gaal can rebuild Manchester United
Kate Bush, Hammersmith Apollo music review: A preamble, then a coup de théâtre - and suddenly the long wait felt worth it

Kate Bush shows a voice untroubled by time

A preamble, then a coup de théâtre - and suddenly the long wait felt worth it
Robot sheepdog technology could be used to save people from burning buildings

The science of herding is cracked

Mathematical model would allow robots to be programmed to control crowds and save people from burning buildings
Tyrant: Is the world ready for a Middle Eastern 'Dallas'?

This tyrant doesn’t rule

It’s billed as a Middle Eastern ‘Dallas’, so why does Fox’s new drama have a white British star?