Can Basel III Work? Examining the New Capital Stability Rules by the Basel Committee : A Theoretical and Empirical Study of Capital Buffers

In the aftermath of the financial crisis, to reinforce the stability of the financial system, policy makers and the Basel Committee have developed proposals to ensure that financial institutions maintain sufficient capital buffers. The December proposal by the Basel Committee outlines fundamental changes and is already being called “Basel III” by the practitioners. It includes a more restrictive definition of Tier 1 Capital, use of leverage ratios, restrictions on discretionary distributions of earnings, and a “bottom-of-the-cycle” calibration for the Pillar I regulatory capital requirements. In this paper we study these proposals first from a theoretical standpoint and then conduct a quantitative impact study. Recent studies and observations support increasing the quality of capital, although a recalibration of minimum Tier 1 ratio will be required. Leverage ratios appear redundant and implementation of them would further complicate the risk optimization problem faced by financial institutions (FIs). Constraining the discretionary distributions of earnings can keep agency costs under control but needs be carefully thought through to make sure that value transfer simply does not take another form and it does not overly interfere with the FI's dividend policies. The “bottom-of-the-cycle” calibration does not look defendable. Among other problems, it could adversely affect the FI's profitability, decelerating the capital built up by reducing the income generation per unit of capital base. Addressing the capital buffer problem within the Pillar II Internal Capital Adequacy Assessment Process (ICAAP) framework supplemented by conditional and forward looking stress testing is clearly the preferred approach