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Basel III and Cushy Capital

posted by Anna Gelpern

BaselCropped The Annual Meetings of the IMF and the World Bank this past weekend were mostly notable for the depth and breadth of political discord underlying the veneer of recent technocratic accomplishment in financial regulation.  So many things can go truly wrong in the next few months, from currency wars to institutional governance, that I was only glad to look on the bright side as I listened to Mario Draghi of the Bank of Italy, chair of the Financial Stability Board, give a thoughtful speech at the Peterson Institute on Friday (I expect they will post a video shortly).  Among the regulatory accomplishmens, he reasonably highlighted the recently agreed revision to the Basel Capital Accords, or Basel III.  For a description, I prefer the speeches here and here to the official press release.  The widely recognized achievement is tightening the consensus definition of bank capital, and building up (over a looooong time) additional cushions to absorb liquidity shocks. 

In other words, this iteration of Basel focuses heavily on the numerator of the capital adequacy fraction, rather than finessing the risky asset denominator.   Yet as I listened to Draghi, I found myself doodling along the cushion metaphor on the margins.  Would strapping ever bigger cushions around the risky asset rocket make us safe?  To be sure, at some point the rocket might just be too heavy to fly too far, and that might be a good thing.  Or all the goose down might get too expensive.  And if the rocket just falls, but does not explode, the cushions might cushion the landing.  Even so, the cushion imagery gets me unsettled.  This too is a good thing -- a reminder that no amount of capital can make up for truly rotten assets, and that asset valuation remains the elusive nub of it.


Your last point remains key for me. Obviously if this worked perfectly, eventually the ratio would simply approach 1 and the financial institution would not do the thing. The obvious problem is when the ratio should be 1 (or wherever the point of unprofitability is), but the bank has figured out a way to keep the actual ratio below that.

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