Mervyn King on Basel III

Basel III on its own will not prevent another crisis for a number of reasons.

First, even the new levels of capital are insufficient to prevent another crisis. Calibrating required capital by reference to the losses incurred during the recent crisis takes inadequate account of the benefits to banks of massive government intervention and the implicit guarantee. More fundamentally, it fails to recognise that when sentiment changes only very high levels of capital would be sufficient to enable banks to obtain funding on anything like normal spreads to policy rates, as we can see at present. When investors change their view about the unknowable future, as they occasionally will in sudden and discontinuous ways - banks that were perceived as well-capitalised can seem under-capitalised with concerns over their solvency.....

Second, the Basel approach calculates the amount of capital required by using a measure of "risk-weighted" assets. Those risk weights are computed from past experience. Yet the circumstances in which capital needs to be available to absorb potential losses are precisely those when earlier judgements about the risk of different assets and their correlations are shown to be wrong. And that is not because investors, banks or regulators are incompetent. It is because the relevant risks are often impossible to assess in terms of fixed probabilities........That is why the Bank of England advocated a simple leverage ratio as a key backstop to capital requirements.....

Third, the Basel framework still focuses largely on the assets side of the bank's balance sheet. Basel II excluded consideration of the liquidity and liability structure of the balance sheet, so much so that when the UK adopted Basel II in 2007, of all the major banks the one with the highest capital ratio was, believe it or not, Northern Rock. Within weeks of announcing that it intended to return excess capital to its shareholders, Northern Rock ran out of money. Basel II was based on a judgement that mortgages were the safest form of lending irrespective of how they were financed. If a business model is based around a particular funding model that suddenly becomes unviable, then the business model becomes unviable too, as events in 2007 showed.