Basel III Clean Up Regulatory Reform Almost a Washout

The new regulatory banking standards called “Basel III” slightly decrease but do not eliminate systemic risk in the banking system, according to research at the University of California, Berkeley’s Haas School of Business. Furthermore, the study suggests successful mortgage markets in Western Europe provide useful models for mortgage reform in the US.  Most notably, these healthier markets do not contain public lenders such as the Fannie Mae and Freddie Mac. As a result, the authors propose the elimination of Fannie Mae and Freddie Mac as a critical step toward healing the domestic economy.

Basel III is a framework of global regulatory standards aimed at making the banking system more resilient and therefore more resistant to systemic risks.

Commissioned by the Financial Markets Committee in Stockholm, Sweden, Professor Dwight Jaffee, also co-chair, Fisher Center for Real Estate & Urban Economics, and Assistant Professor Johan Walden, sought to understand the effects of Basel III on consumer lending rates and determine whether the global regulatory standards would mitigate systemic risks that caused the 2008 financial crisis.

In their report, The Impact of Basel III and Solvency 2 on Swedish Banks and Insurers – An Equilibrium Analysis, Jaffee and Walden determine the banking and insurance regulatory reforms produce minimal effects – at least in Sweden.

“It is not going to have negative effects but it is not going to make significant positive differences either, says Jaffee, who argues the findings derived from the Swedish economy are important to the US economy.  He explains, “The US financial systems remain highly exposed to a future systemic crisis and looking to other economies, like Sweden’s, may be helpful.”

In addition to systemic risk, the study focused on the costs associated with raising new bank capital and insurer requirements, the possible congestion created in the existing markets for corporate bonds, and the redevelopment of financial channels – including securitization and the increased use of global sources. How will Basel III influence borrowing rates and GDP growth? By less than one percent, says Walden.

“One of the changes is that banks will have higher capital ratios which measures how much equity the bank has compared to how much debt.  A higher ratio leads to lower risk but it might also lead to higher borrowing rates for customers because swapping debt into capital reduces the tax shield benefit of the debt. When we did the numbers, it just came out that the effect in terms of raising interest rates and reducing GDP growth will be very, very small,” says Walden.

The three main findings of the study conclude that because new regulations will be implemented over a long period of time (through 2018), any “supply shocks” on bank lending, will be minimal. Also, the new regulations do not completely eliminate the key sources of systemic risk for Sweden’s small open economy, namely, mortgage risk and the inevitable influences of changes in the global economy. And finally, as Swedish banks and insurers pass increased costs to customers, customers will seek alternative financial suppliers, supporting an expansion of new markets – a positive result, the researchers conclude.

“Basel III does put in some additional requirements concerning mortgages and how they would be treated by the banks. And I hope that as the US reforms our mortgage market, they will take that into account,” says Jaffee. “We need to remove Fannie and Freddie and to build up a regulatory structure that anticipates a greater volume of mortgage lending going through the banks. You need strong Basel III requirements and very good regulators overseeing it.”

Beginning in 2013, European Union insurance firms will be subject to Solvency 2, the updated regulatory requirements for EU insurers. The goal is to reduce the risk that insurers would be unable to pay claims. Jaffee and Walden say their evaluation was limited due to the regulation’s “preliminary state.” However, they say the effect of the increased insurer capital requirements will in large part be determined by how consumer policyholders respond to changes in premium prices, and -- most importantly, whether policyholders recognize that the increase safety warrants the higher premiums.

The Jaffee and Walden Reports, including the main report, an executive summary, and an appendix, are available on the web at: http://www.sou.gov.se/fmk/rapporter.htm

Watch Professors Jaffee and Walden talk about their research.

[This article has been reproduced with permission from Haas Research, published by the University of California, Berkeley's Haas School of Business]