A global fight over banking rules is just getting started

Co-operation on the financial system will be the casualty

ALMOST 18 YEARS ago, amid the global financial crisis, a document was released which was to have a profound impact on the banking system. The snappily named “Principles for Sound Liquidity Risk Management and Supervision” was penned by the Bank for International Settlements (BIS), a club of central banks. Walter Bagehot’s “Lombard Street” it was not; the principles are a dull read even for a financial nerd. But the report eventually led to the “Basel III” rules on banking supervision, named after the BIS’s Swiss home—and hence to vast new protective capital buffers.

The rules are, to most observers, a success. But like many products of the bygone era of multilateralism, they are beginning to fray, as America and Europe disagree about their future. In a world of wars—commercial and kinetic—battles over capital requirements may seem peripheral. Yet if they bring about an era of deregulatory competition, they could store up a lot of trouble.

American rulemakers are the most trigger-happy. In March the Federal Reserve reduced extra capital charges for the biggest banks and relaxed some of the more onerous Basel “endgame” rules proposed in 2023. Morgan Stanley, an investment bank, reckons these and other manoeuvres will free up as much as $54bn in capital—which in banks’ case more or less means equity—across the banking sector. This means the system can become more leveraged.

The Fed’s most belligerent decision has been to drop the concept of an “output floor” enshrined in the Basel accords. This is a backstop meant to limit how much banks can rely on their own assessments of the riskiness of their assets, which they have an incentive to underplay. Ironically, the output floor was a victory for American regulators, who squeezed the concession from their European peers in 2017.

Since banking is a global business, European lenders fear a competitive disadvantage if they face stricter rules than their American rivals. The Association for Financial Markets in Europe (AFME), an industry group, complains that 11.8% of EU banks’ capital is “common-equity tier 1”, the safest sort, compared with 10.1% in America. AFME’s proposal for cutting European capital requirements by around 2.3 percentage points would free up €281bn ($329bn) in capital.

In December the Bank of England, which in 2023 was given a secondary mandate to promote international competitiveness and growth, launched a pre-emptive strike against the long-awaited American rule changes. It eased the overall capital requirement for British banks from 14% to 13% of their risk-weighted assets. It was the first such reduction since the current rules were put in place a decade ago (albeit one that is Basel-compliant). On April 22nd the European Commission, the EU’s executive arm, said it might delay by three years Basel rules for how banks calculate risk capital for trading activities, which were due to come into effect next January.

Some regulators are staying out of the fight. In mid-April the Swiss government confirmed its new steep capital requirements, provoking howls of protest (the requirement for UBS, the country’s last megabank, rose by some $20bn). And, taken individually, relaxing a rule here and delaying one there can often be defended on the merits. Technocrats in Basel, Brussels or the Beltway had sometimes gone too far. The Fed’s rush in 2023 to implement the international rules led to onerous gold-plating, such as raising the risk-weighting of mortgages far above Basel standard.

But although such bending or even breaking of individual rules can occasionally improve national regulation, the trend towards lower capital is dangerous. Finance is more prone than most industries to catastrophic failure—and, because it is also more globally interconnected, a local blow-up can ignite a worldwide chain reaction. Moreover, as the transatlantic tit-for-tat illustrates, unilateral action inevitably provokes more unilateral action. Even the stiff-spined Swiss may eventually relent, especially if UBS threatens to decamp from Zurich’s Bahnhofstrasse to Wall Street (rumours of which the bank has repeatedly had to deny).

Just because rules for international finance took two decades of careful diplomacy to draft does not mean they cannot be undone in a jiffy: just ask the World Health Organisation or NATO. As memories of the last financial crisis fade, the capital wars are likely to intensify. Brace for impact. ■