As Basel III is driving the implementation of Basel II, banks are seriously reviewing everything through the eyes of the regulatory framework. This is a consideration when choosing customers, developing pricing policy, reorganizing, reducing staff, structuring products and transactions, and choosing which countries to work in. In other words, Basel is driving real-life business decisions to a greater degree than anything seen in banking before.
Unfortunately, Basel is a regulatory framework: a model. As yet, no human model has ever fully been able to fully model complex real-world events. The Basel models also have not worked. Look at 2008. Basel II did not work. Basel III is adding complexity without any real assurance that the final implemented version will have any real chance of preventing the next crisis. (Is that even a realistic objective?) The real tangible benefit of Basel III will be to increase the capital that banks hold. This is good, but the complexity is adding costs and hidden risks.
It is arguably easier to circumvent very complex regulations than very simple ones. Indeed, this has been put forward as one of the reasons that no bankers have yet been prosecuted for not following the rules and regulations already in force in 2008-2009. Loopholes can be found in any set of regulations, but the complexity of Basel will ensure that any circumvention will be even more complex. Therefore, the stability of the entire system may actually be reduced through the creation of ever more incomprehensible investment vehicles and financial legal structures.
More complexity leads to one certainty. Banks will need substantially more people and resources working on compliance issues, while society will need ever more and more sophisticated regulators.
As banks emulate the world of Basel in real life, we could see more reliance on product profitability rather than customer profitability. The basic premise of relationship banking could be under threat, in order to achieve short-term financial results. The ownership of banks is also likely to change. It is hard to see many of the current owners of banks being satisfied with 8 to 10 per cent long-term return on investment levels.
The market distortion of Basel, together with the market distortion of policy-makers’ support for banks during the crisis, ensure that many banks that should have failed will live, while others that would have lived will die. This is a dramatic compounding of the moral hazard that has been a common thread throughout this crisis. This will most certainly decrease the public faith in the banking industry.
Once the die-off has occurred and competition is reduced, the remaining banks may adjust their pricing according to regulatory models that do not reflect business or economic rationale. This would make the banks less efficient as businesses. Basel is already leading banks to terminate some long-term customer relationships, in order to manage short-term requirements. To the people involved on both sides, this is a pity.
Yet the most striking, but little-mentioned, consequence of the Basel framework is that it makes the banking system much less transparent.
Given that risks are modelled by internal data for each portfolio, it is not possible to fully compare any two portfolios, let alone any two banks. This is further compounded by the use of different approaches, which are also not comparable. Given that so many business processes and decisions are impacted upon by Basel, this lack of Basel transparency also shrouds everything else the bank is doing. There is no way for a bank analyst to be able to see a particular business or strategic decision as related to regulatory impact, if that information is not made explicitly public. The risk- adjusted return on capital at risk for any particular bank has no analytical relevance outside of the financial institution. By definition, these returns cannot be compared across banks.
Unfortunately, Basel has not altered the real-life fact that markets with more information are more efficient than markets with less information. Of course, there could be other positive consequences. The drive towards efficiency, if managed correctly, should substantially improve the level of service quality and the long-term financial stability of the surviving banks. In other words, society will have better banks.
If Basel were to force a change of ownership to those investors looking for lower risk at lower rates of return, then once again society could benefit. Less profit maximization in the financial industry should lead to less unhealthy risk-taking.