Basel III attempts to do two things: to apply the concepts of new risk-management techniques in banking to the supervision of banks and to encourage the widening and deepening of the application of these concepts to the largest and most complex internationally active banking organisations. It is apparent from the 2 rounds of public consultation culminating in the agreed Guideline that attempts to respond to the deficiencies in financial regulation revealed by the global financial crisis.
But at the same time that volatile markets are occasionally stuttering along something else is happening. Capital market arebeing replaced by multiple micro markets and the long tail of choice. The concept of micro lending has been around for some time but is now more readily acceptable to major banks. In my previous post I mentioned about how the exchange of information creates ever more value, while commodity products and ideas are ever cheaper.
Right before your eyes, a fundamentally different economy, with different players and different ways to add value is being built. What used to be an essential asset (for a person or for a company) is worth far less, while new capital can be both scarce and valuable.
Are there dislocations? In other words, will the new economy present intrinsic Basel implementation difficulties? Quite possibly.
It is true that the ideas embodied in Basel II began inside banks themselves; but not all banks are using all the concepts, and the advance across banks has been uneven. Increasingly investors and counterparties are asking whether they are being used, and Basel II adds to such pressure. Running through all three pillars of the Basel II proposal is encouragement for banking organizations to invest in and improve their risk-management capabilities. The advanced approaches to credit risk will require large banks to analyze their credit exposures in a formal and systematic way, assigning both default and loss probabilities to such exposures.
Basel III however is more rooted in modern finance. It seeks to develop in the larger banking organisations a comprehensive, systematic approach to assessing the various risks to which they are exposed as a matter of established culture. It attempts to develop and make more mature the previous frameworks.
Inevitably it raises both the supervisors' and the market's expectations for banks' risk-management systems. It clearly will increase the resources and management attention devoted to the details of risk management, focusing attention on the kinds of risks being taken and the potential losses that may accompany them.
It is exactly that kind of attention, that kind of support for the risk managers, that will minimize the procyclical swings that have historically marked the bank credit cycle: unintended risk-taking from an overly optimistic view followed by intervals of limited credit availability for even low-risk borrowers as pessimistic views came to the fore. Unintended risks are neither priced correctly nor adequately reserved or capitalized. Reductions in credit availability limit economic growth.
This is why the current mass/micro market, the opportunity, though, is the biggest of our generation (or the last one, for that matter) is paradoxical. Opportunities are there for anyone (with or without a job) & smart enough to take it -to develop a best in class skill, to tell a story, to spread the word, to be in demand, to satisfy real needs, to sell, run from the mediocre middle and to change everything. This is the Facebook/Zopa et al generation.
As the scale and scope of banking has increased and as banking systems have become more concentrated, the effects of mistakes from excessive risk-taking and reductions in credit availability on national and world financial markets and economies has simply become too large to tolerate. The alternatives to strengthening risk management are limited and not very attractive: prohibitions on activities or very intrusive supervision and regulation. Bank managers and stakeholders, as well as those who believe in the market process, have an important stake in making Basel III work because we have already recently witnessed the alternative.
But whereas the old economy offered a guarantee:
time + education + obedience = stability
There is no such guarantee with the new economy and this presents both a conceptual and a practical hurdle.
