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Financial 411: Central Bankers Address Reform

Monday, September 13, 2010

Investors were cheered by new global banking rules, positive economic data from China and some acquisitions. The Dow jumped 81 points, to close at 10,544. The S&P 500 rose 12 points, to 1,122, and the Nasdaq improved by 43 points, to 2,286. Banking shares got a boost after central bankers addressed issues of bank reform at a weekend meeting in Basel, Switzerland.

And a potential compromise on extending Bush era tax cuts only to those making less than $250,000 a year could be thwarted by Connecticut Sen. Joseph Lieberman. Lieberman, an independent who is aligned with Democrats, says he favors maintaining the lower rates for everyone, including the wealthiest Americans, for at least another year.

The Basel 3

It was this week, two years ago, that Lehman Brothers filed for bankruptcy -- the largest on record. With Lehman's collapse, the nation's financial sector went into a severe tailspin and dragged the nation's economy into a deep and prolonged recession.

This weekend, the world's central bankers agreed to new rules aimed at preventing this sort of financial catastrophe. Called Basel 3, the new rules, in part, will require banks to hold more capital to protect them from future losses. While this may sound very inside baseball, or inside banking, the rules could have repercussions for average borrowers and businesses here in the U.S.

Karen Petrou, managing partner with Federal Financial Analytics in Washington, D.C., discusses the Basel 3.

First of all, what exactly did the central bankers agree to with these Basel 3 rules?

They set the numbers. We had a proposal and we knew what was going to be in them, but we didn't know how much capital would be required in this new scheme. And yesterday, the central bankers and heads of supervision put some numbers to them, so we know not only how much capital banks will have to hold, but how long they will have to raise it to come into compliance with these overall tough new rules.

And explain what capital is and why the central bankers thought that in order to prevent the meltdown of 2008, banks need more capital.  

Simply put, capital is what shareholders invest in a bank. It's common equity, so that their money is ahead of yours and mine. This not only buffers the bank against risk by putting shareholder money first, but the goal is also that it creates much better discipline so that people management care about take a loss if undo risk is taken.

And I take it that these rules were directed exactly at this 2008 meltdown. Do you think they will do as intended, prevent what we saw happen with the global financial collapse?

They'll help a lot. I think one of the conclusions we all agree on was that the 2008 debacle was caused in part by what's called over-leveraging -- taking big bets with nobody's money but the taxpayers, or the FDIC's. And if you have to put shareholder money first, banks will take less risk, and if they still manage to take risk, shareholders will take a hit, and that's going to help a lot. Is it perfect? No, but it's a lot better.

Do you think banks will look for ways around these rules? And if so, does that mean possible failures in the future? You know, after all, we put in place these rules to address things that happened in the past, without knowing what's going to happen in the future.  

I think one can safely say there will always be bank failures. And the struggle is to fix the things we know are wrong, and then going forward to watch for the new challenges. This is a critical fix to what we know. But does it mean we can just relax and say banking is safe forever? No, of course not.  

So what's the downside, that they could reduce the availability of credit, or push up interest rates? How is this going to affect consumers?

It's a balancing act, because the higher bank capital requirements, the less profitability. And if banks try to keep their profits up, they will look for new ways to make money, and that might come from higher fees, or larger interest rates. I think it's going to come also from taking less risk, which is of course the goal. And that's a good thing because some of the speculative and even predatory types of products that got us into this fix will now bear a punitive capital charge, and I hope we see the end of them.

So, does this mean higher mortgage rates, or interest rates for loans?

It could. It depends on who the borrower is. One of the nice things about these rules is they also reduce the capital charges for the best mortgages, so you're going to see a better differentiation of risk in the rules, and I think that's going to lead to ongoing credit availability for qualified borrowers, and I hope an end to some of the predatory or high-risk products that the previous capital rules really encouraged.

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