George G. Kaufman (Loyola University Chicago) For Presentation at FDIC September 13, 2006

1. Basel II Has Been a Costly Distraction on the Road to Minimizing the Societal Cost of Bank Failures George G. Kaufman (Loyola University Chicago) For Presentation at FDIC September 13, 2006

2. Objectives of Public Policy Towards Banking • Safety – minimize adverse externalities of bank failures by minimizing credit and liquidity losses • Efficiency – permit exit of inefficient and/or unlucky banks without infecting other banks and at minimal cost

3. Public Policy Provisions to Achieve Objectives • Framework to turn troubled banks around before failure --- PCA to supplement market discipline • Mandatory legal closure rule at positive capital – regulatory insolvency (minimize credit losses) • Least cost resolution to insurance fund -- loss-sharing with uninsured claimants (minimize moral hazard and maximize moral discipline)

4. Public Policy Provisions to Achieve Objectives (cont.) • Speedy transfer of and access to recovery value of assets and uninsured claims and par value of insured claims to other/bridge bank – no physical closure (minimize liquidity losses) • Prompt reprivitization of bridge bank at sustainable capital

5. Requirements for Activating Provisions • Timely and accurate data • Useful measure of bank capital • Market discipline to supplement regulatory discipline • Credible provisions for enforcement of required actions/sanctions, including legal closure, when capital ratios violated or threaten to be violated. • Public disclosure of how large banks will be resolved – ex-ante rules of game

6. Objectives of Basels • Basel I • Obtain “useful” capital measure (risk-based) • Basel II • Expand risk-based capital measure (Pillar 1) • Include role for supervision (Pillar 2) • Enumerate public disclosure items (Pillar 3)

7. BUT Basel Provisions Fall Far Short of Satisfying Requirements for Minimizing Credit and Liquidity Losses and Achieving Financial Stability • Pillar II – No mandatory supervisory actions, therefore only list of “best practices”. Does not prevent forbearance. No adjustment for difference in quality of supervision across countries. • Pillar III – No provision for strengthening “at-risk” provisions of de-jure uninsured claimants. Little impact on market discipline. • Pillar I – For public policy purpose. No evidence that new capital measure meaningful or better than simpler leverage ratio. No mandatory “legal closure rule”. Increases opaqueness. Why?

8. No Evidence Model-Based Risk Capital Meaningful • Recent quantitative impact studies of Basel II QIS4 in U.S. show strange and unacceptable results. Perceived equally risky banks have greatly different computed capital requirements and similar activities within banks have greatly different computed capital requirements across banks. Fat tails/no tails. Complexity sufficient justification over simplicity and transparency? Some large banks now opposed. • For many large banks would lower regulatory capital requirement below 4% tier 1 leverage ratio that defines “adequately capitalized.” Thus leverage ratio is constraint. Lobby to lower numerical trigger? Are banks overcapitalized now? Would lower capital help?

9. Ranges of Minimum Required Capital (MRC) Changes for Various Credit Portfolios As Indicated by QIS-4 Results Source: Powell Testimony, 11/10/05

10. Range of Minimum Required Capital (MRC) Changes for Wholesale Portfolios Source: Powell Testimony, 11/10/05

11. Range of Minimum Required Capital (MRC) Changes for Retail Portfolios Source: Powell Testimony, 11/10/05

12. Large Bank Capital Ratios and Profitability by Country Source: FDIC, FYI: An Update on Emerging Issues in Banking, p. 1 & BIS Annual Reports 2001-2003

13. Top 100 Capitalized Banks in the World, 2004 by Geographic Region and Share of Total Assets, Tier 1 Capital, and Pretax Profits Source: Banker Magazine, July 2005

14. Cost of Basel II Exercise • Focus primarily on 1 issue – “better” measure of bank capital – with at best mixed results. More recent refinements “exercises in minutia”. Absorbs way out of proportion highly skilled manpower and financial resources. • Takes eye of real issue – improving stability of the banking/financial system. More than measure of capital and good intentions. Comprehensive plan, e.g., US style SEIR superior structure for public policy.

15. Resources Better Used Elsewhere • In U.S., designing and simulating large (TBTF) bank resolution process and publicly disclosing plan, issue financial stability report, join IMF-WB Financial Sector Assessment Program (FSAP) • In other countries, developing legal closure rule and PCA similar to U.S. and legal prerequisites (separate bank bankruptcy code). Enhance availability of timely and accurate data. Improve quality of supervision. • In EU, preparing appropriate deposit insurance and closure rule provisions for single license cross-border branching in light of confusion from multiple insurance systems in country and home-host country conflicts from home country responsibility for deposit insurance and closure of branches in host countries. No single deposit insurance agency or bankruptcy code. Need to deal with “dark side” of cross-border banking. Otherwise cross-border branching may not occur.

16. Conclusions • Basel II has taken eye of major public policy objective • Basel II has absorbed massive resources that could have been put to better use. Badly fails cost-benefit test. • Most countries appear little, if any, better off in reducing costs of banks crises than at beginning of Basel II. • Thus, high opportunity cost. • Should quickly redirect resources to broader public policy objectives of elimination adverse externalities of bank failures. Curtail Basel II refinements.

17. “Those that cannot remember the past are condemned to repeat it”. --George Santayana (1905) Remember ignore, forget Condemned doomed Repeat relive But what do those who remember the past do? “Those that remember the past, agonize first and then repeat it” --George G. Kaufman

18. Paraphrasing President Ronald Reagan “Mr. Basel, let those resources go.”