Implementing Basel Capital Requirements: The Dark Side

Following the recommendations of the Basel Committee on Banking Supervision, most financial systems around the world have imposed new capital requirements for banks in recent years. These moves seem to be justified on two powerful economic grounds. First, better capitalized banks promote financial stability by reducing banks’ incentives to take risks and increasing banks’ buffers against losses. Second, lack of compliance with a set of rules established by an internationally recognized institution such as the Basel Committee may harm confidence in a country´s financial system.

In a recent paper (available here), however, we argue that the implementation of Basel capital requirements may be socially undesirable, at least in some countries. First, as shown in many empirical studies (see, for example, Ma et al, 2013; Aiyar et al, 2014; Remolina, 2016), higher capital requirements may reduce people´s access to finance by either increasing the cost of debt or reducing the volume of loans. Moreover, while this contraction in the availability of credit may be harmful for any economy, it will generate a greater impact in emerging markets, taking into account their less developed capital markets and their greater problems of financial exclusion (i.e., problems associated with access to finance and, more generally, to financial services). Therefore, the implementation of Basel Capital requirements will be even more harmful in these countries.

Second, the one-size-fits-all model followed by the Basel Committee does not take into account the particular features of a country´s financial sector. Indeed, even though the stability of the financial system is a primary goal worldwide, legal and accounting rules may vary across jurisdictions, and each financial system may have different problems and infrastructures. For example, while the United States faced in 2008 one of its most serious financial crises due to a combination of problems mainly related to a housing bubble and the securitization of mortgages, the situation was quite different in countries like Spain or Colombia.

The Colombian financial system did not suffer any major financial problems in 2008. The reason was, on the one hand, that Colombian banks did not hold on their balance sheets asset-backed securities or collateralized debt obligations associated with U.S. subprime mortgages, and, on the other hand, they were not exposed to the contagious financial problems that spread quickly among many banks in the United States and the European Union.

Another example can be found in Spain, where the major financial problem in 2008 was not the international financial crisis but a combination of various internal problems (see Gurrea-Martínez, 2013). First, Spain had its own housing bubble. Second, and more important, during the  financial crisis there were three major types of financial institutions allowed to lend money and receive deposits in Spain: (i) banks (strictly speaking); (ii) cooperatives of credit; and (iii) savings banks. From a legal perspective, banks are corporations, and most of them list their shares on financial markets (e.g., Santander, BBVA, etc.). So they have shareholders, and, perhaps more important, they are exposed to the scrutiny of the market. Cooperatives, on the other hand, are a type of non-profit organization owned and managed by the people who use their services.  Finally, savings banks (cajas de ahorro), from a legal perspective, were foundations. They did not have shareholders; they were not subject to any form of market scrutiny; and politicians exercised strong influence over them.  However, unlike in the United States, these institutions were not engaged in any complex financial activities. The failure of these financial institutions was mainly due to a corporate governance problem. For these reasons, the primary problem of the Spanish banking system was not Spanish banks but these saving banks. In fact, none of the major Spanish banks were bailed out. All the money injected into the Spanish banking system was given to these savings banks. Therefore, the origin of the Spanish financial crisis was not directly related to the U.S. financial crisis. Instead, it was an internal problem.

In our view, the recommendations of the Basel Committee are to some extent skewed toward the problems of the most powerful members of the Basel Committee. Therefore, the committee’s one-size-fits-all approach can encourage (almost force) the implementation of some policies that, in some particular countries, might be inefficient, ineffective, or unnecessary. At the same time, these policies, in other circumstances, might not properly address real problems existing in a particular financial sector.

Based on the aforementioned issues, our paper proposes three policy recommendations aimed at promoting a more resilient financial system without hampering access to finance and imposing undesirable costs for a country´s financial system. First, we propose changing the tax system to favor, rather than require, the capitalization of banks. That means abolishing the tax benefits of debt (at least for banks) and allowing the deductibility of an implied interest (or cost) of equity, as is the case in Belgium. Second, we believe that, as is the case in similar institutions such as the International Organization of Securities Commissions (IOSCO), the Basel Committee should create regional committees to get a better sense of a country´s particular features. Third, due to the fact that the problems, features, and infrastructure of a country´s financial system vary around the world, we also urge investors, governments, banks, and credit rating agencies to abandon the implicit assumption that the adoption of Basel Accords is always desirable for a country´s financial system. Instead, we advocate for a deeper analysis of country-specific financial features. For this reason, the assessment of a country´s financial system currently based on a ‘comply or comply’ model (in which countries or institutions must comply with regulations if they do not want to be punished by the market) or, in the best scenario, in a ‘comply or explain’ approach (in which countries or institutions may either comply with the law or explain why they will not) should be substituted for an ‘apply or explain’ model. Under this latter approach, countries or institutions would be able to either ‘apply’ the suggested rule or ‘explain’ why they are not complying with the law. In both cases, however, it would be clear to market participants that the country (or institution) is complying with the law.

This post comes to us from Aurelio Gurrea Martínez and Nydia Remolina León. Aurelio Gurrea- Martínez is a teaching fellow in capital markets and financial regulation and fellow of the program on corporate governance at Harvard Law School, executive director of the Ibero-American Institute for Law and Finance, and a lecturer in comparative business law at the Centro de Estudios Garrigues. Nydia Remolina León is legal advisor for innovation, digital transformation and strategic affairs at Bancolombia, lecturer in banking law at the Pontificia Universidad Javeriana, and research associate at the Ibero-American Institute for Law and Finance. The post is based on their recent paper, “The Dark Side of the Implementation of Basel Capital Requirements: Theory, Evidence and Policy,” available here.

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