Though meant to minimize risk of a future crisis, the new rules’ complexity will degrade supervision and reduce financial stability. Simple “bright line” rules are the most easily understood and enforced

The U.S. is in the early stages of implementing Basel III, a new set of regulations that will determine the minimum levels of capital for banks and bank holding companies. It is essentially a very detailed rulebook that sets capital requirements for banking institutions.

Basel III has been widely applauded for raising large banks’ capital requirements but unfortunately it does not stop there. The new complex regulations include business cycle-dependent capital surcharges, minimum liquidity rules, a leverage ratio surcharge for systemically important institutions, and many additional requirements to plug loopholes in Basel II rules that became apparent in the recent financial crisis.

Once the Basel rulebook was reopened, many new, unproven, and complex features were added to the regulations. The truth about Basel III is that no one is really sure if any of the additional complexities will work, and each brings additional costs and risks.

The most obvious costs of Basel III include large direct bank compliance costs. The less obvious costs will be the indirect social costs that arise when these rules skew bank investment decisions away from otherwise sound economic investments into favoured investments where Basel III risk-weighting understates the true risks. Although it will take time for these risks to materialize, they are real and costly, and they will materialize.

The most important but least discussed risk created by Basel III is that its complexity will degrade the quality of supervision and end up reducing financial stability. Common sense suggests that complex rules are likely to be difficult and expensive to enforce. Basel III is by far the most complex set of bank regulations that have ever been attempted.

Experienced bank frontline supervisors will tell you that simple “bright line” rules are the most easily understood and enforced. Regulations more like the U.S. leverage ratio and less like Basel III are preferred on basis of simplicity and transparency. Regulations that use quantities that can be accurately and objectively measured and used to require well-defined ratios or minimum coverage levels are difficult to game.

And even when regulatory rules are simple, difficulties still remain. For example, even a basic leverage ratio — bank book equity to book assets — can be the subject of bank-supervisor controversy because the adequacy of provisions for loan loss impairments is subjective and open to debate.

For the largest banks, so-called Basel III advanced-approach banks, verification is especially problematic. For these banks, Basel III risk weights are set using the bank’s internal models that classify loans into internal credit grades, each of which has an associated bank estimate of projected default and loss performance. Many complex issues now arise. Are the loans assigned to the right buckets? How can one tell? Does the bank have historical data to support its projections of default and loss rates for each of its risk buckets? Should the bank be allowed to “adjust” its observed default rates to “correct” for the business cycle? Are the data the bank is using cherry-picked to include only profitable years? Are the statistical and econometric methods used to make the estimates accurate and appropriate?

Banks’ historical data and modeling accuracy often are suspect, but an examiner must still arrive at a judgment as to whether a bank’s estimates are “good enough” to satisfy the capital regulations.Many of these judgments are difficult even for PhD statisticians and econometricians, so it is not surprising that frontline bank supervisors have difficulties enforcing such a complex standard.

When the rules are as complex as Basel III, while the rules look prescriptive, in reality the veracity of the rules depends more than ever on interpretation and judgment of the examiners evaluating the bank’s compliance. A recent real case study substantiates the gravity of this issue.

Recently, two different U.S. federal bank supervisory agencies examined an institution. One supervised the bank holding company (BHC) and the other the depository institution (bank).The supervisors conducted independent assessments of the institution’s market risk models and measurement systems. One supervisory agency approved the institution’s application to use internal models for its trading book capital requirements while the other agency found that the institution did not satisfy any of the regulatory requirements needed to use its internal models. Moreover, the market risk measurement system used by the bank and the BHC were exactly the same — the same data, the same models, the same risk managers.

Complex regulations may give the appearance of rigour, but in reality they will fall short if they are too complex to enforce. Basel III is just too complex to be effectively or consistently enforced, no matter how talented the bank examination force.

Some sensible policymakers have begun to question the benefits of complex regulations and are arguing for reforms to reduce the complexity of regulatory capital rules. This initiative must be encouraged as it must overcome massive inertia generated by the industry and regulatory investments that have been made in the current approach. Future revisions to bank minimum capital regulations should be targeted to improve transparency, reduce complexity, and recognize the practical limits to verification.

Paul Kupiec, an American Enterprise Institute resident scholar and author of Basel III: Some Costs Will Outweigh the Benefits, was director of the Center for Financial Research at the Federal Deposit Insurance Corporation.