Bair: US should pull back from Basel II

The US should back away from the "highly problematic" Basel II framework and instead turn its attention to fine-tuning the current Basel I Accord, Federal Deposit Insurance Corporation (FDIC) chairman Sheila Bair said yesterday.

Speaking before the Senate Committee on Banking, Housing and Urban Affairs, Bair was asked whether she would consider pushing for the retention of Basel I as the primary risk management framework in the US, in light of the capital adequacy relief the accord has provided some of the biggest financial institutions posing large systemic risks to global financial markets.

"The structure of the Basel II advanced approaches has been highly problematic but we still have the leverage ratio in place in this country and discussions are now taking place internationally regarding a global leverage ratio. A more granular Basel I framework could be more effective than Basel II and I think that it would be a viable and faster path to stronger capital standards," Bair said.

Bair noted many of the concepts "inherent in the Basel II advanced approaches [resulted] in reduced capital requirements. In hindsight, it is now clear that the international regulatory community over-estimated the risk mitigation benefits of diversification and risk management when they set minimum regulatory capital requirements for large, complex financial institutions".

Bair took the opportunity to lay her vision for overhauling financial regulation in the US before senators and advocated a 180-degree move away from Basel II capital standards, saying instead that systemically important firms should face additional capital charges based on their size and complexity.

This should both dissuade institutions from growing too large or complex while simultaneously coercing existing systemically important entities to shrink or simplify their business lines to secure capital relief, she said.

In addition to plans already announced by the US Treasury to establish a systemic risk regulator - a role that Bair noted "the Federal Reserve would seem well positioned" to fill - the FDIC also called for the creation of a systemic risk council to bring together the Treasury, the Fed, the FDIC and the Securities and Exchange Commission to assess system-wide threats and take a more macro perspective of emerging problems than individual regulators do.

The council would have "the authority to overrule or force actions on behalf of other regulatory entities", Bair said. The FDIC would also be empowered with new resolution authority to create a legal mechanism to facilitate the orderly unwinding of failing systemically important firms.

Current rules only allow the FDIC to intervene at FDIC-insured institutions' deposit-taking arms rather than regulating bank holding companies in their entirety. In extending existing powers, the FDIC would be able to permit the swift and orderly dissolution of a whole firm, moving healthy and insured assets across to a bridge bank and ultimately to another viable institution while providing counterparties the scope to avoid immediately terminating outstanding derivatives positions and selling collateral on those positions at fire-sale prices, which would depress prices and increase the systemic impact of the collapse of a counterparty.

Current bankruptcy provisions do not allow for the orderly resolution of outstanding derivatives contracts - as witnessed following the collapse of Lehman Brothers in September 2008.

Funding for the authority would be provided through a "financial companies resolution fund" similar in design to the existing deposit insurance fund, towards which all systemically important firms would contribute funds - based on their risk profile - to finance the unwinding of any other major institutions caught in the system. This fund would serve as a further capital disincentive to compel systemically important firms to shrink in size.

Senators reacted positively to the proposals, commending Bair on her free-market ideals and contrasting her ideas to those put forth by Treasury secretary Timothy Geithner, who has dramatically expanded the size of the US government balance sheet to finance several programmes designed to revive capital markets and hasten the end of the recession.

"FDIC chairman Bair's testimony is a stunning rejection of what we have heard from our Treasury secretary. I want to thank you for bringing sanity to the situation. This proposal alleviates much of the moral hazard that the Treasury secretary has been promoting," said Republican senator Bob Corker.

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