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Implementing Basel III Capital Rules in the US Financial System

Basel III is an international agreement designed to improve stability in the banking industry in the aftermath of the 2007-09 crisis.  The agreement begins with a light touch but phases in over the next several years to a level where most banks would be required to have three times as much top-quality capital as is currently required.

The Fed will ease some requirements that would be tough on community banks, but they also want to add four rules aimed at big US banks.  These rules would go beyond Basel III requirements because financial officials believe the Basel III rules do not go far enough in terms of protecting the financial system. 

When banks hold more capital, there is less money available for loans to those with less-than-stellar balance sheets (which means no loans or at best higher interest rates for those borrowers).  The immediate take-away is that now is a great time to borrow as borrowing conditions could get tougher and more expensive in the coming years.

FDIC official Tom Hoenig said that Basel III allows banks to give the appearance of healthy capitalization even when the reality is much different. This weakness is due in part of the fact that banks could have the flexibility to use complex procedures to evaluate the risk on current loans and thus potentially undermine the spirit of the agreement.  He is, of course, correct.

There is always a way to work around complicated guidelines and no amount of government regulation can produce a risk-free system.  That is one of the lessons of 2007-09.  Basel III, and the Fed’s additional rules (if implemented), will not solve all the problems, but they may help build confidence in the banking system.  That is incredibly important.

Please keep in mind though that there is always a cost, and in this situation, that is likely to mean higher borrowing costs and potentially a slight drag on economic growth.

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