Economists question Basel III underpinnings

David Walker
World leaders sit down today at the Seoul Group of 20 meeting to approve the broad shape of the new Basel III financial regulatory regime. As they do, 20 of the world's leading finance economists have published a letter in the Financial Times condemning the system and recommending tougher rules.

The 20 include the University of Chicago's Eugene Fama and John Cochrane, the London School of Economics' Charles Goodhart and Princeton's Markus Brunnermeier. Fama's presenece is significant because of his role as originator of the "efficient markets hypothesis", a concept frequently cited by proponents of financial deregulation.

The economists argue that the Basel III rules "fail to eliminate key structural flaws in the current system" including banks' high leverage.

"If a much larger fraction, at least 15 per cent, of banks' total, non-risk-weighted, assets were funded by equity, the social benefits would be substantial," they say. "And the social costs would be minimal, if any." They say bankers' warnings against higher equity requirements are misplaced.

The 20 particularly criticise the system of risk weights used by the Basel rules.

"This system encourages 'innovations' to economize on equity, which undermine capital regulation and often add to systemic risk," they write. "The proliferation of synthetic AAA securities before the crisis is an example."

Requiring banks to hold more equity would "sharply reduce the likelihood of crises", they conclude.

For more, see our Basel II backgrounder.