Easing of Rules for Banks Acknowledges Reality

When a global committee of regulators and central bankers agreed to a new set of rules for the banking system a year and a half ago, Jamie Dimon, the chief executive of JPMorgan Chase, told The Financial Times, “I'm very close to thinking the United States shouldn't be in Basel anymore. I would not have agreed to rules that are blatantly anti-American.”

Over the last weekend, Mr. Dimon finally got what he had wanted: a form of deregulation of sorts. The new international capital requirements for banks, known as Basel III - apologies if your eyes are glazing over - were significantly relaxed by regulators.

Instead of requiring banks to maintain, by 2015, a certain amount of assets that can quickly be turned into cash, the most stringent deadline was pushed to 2019. Perhaps more important, the type of assets that could be counted in a bank's liquidity requirement was changed to be more flexible, including securities backed by mortgages, for example, instead of simply sovereign debt.

This sounds boring, but it is important stuff. Increasing bank capital and liquidity requirements - think of it as the size of a bank's rainy day fund - is arguably more significant than all of the new laws in the Dodd-Frank Wall Street Reform and Consumer Protection Act. The more capital a bank is required to hold, the lower the chance it could suffer a run on the bank like Lehman Brothers did in 2008.

Given memories of the financial crisis, the idea that regulators would loosen rules even a smidgen is considered a huge giveaway. The conventional wisdom is that the banks are the big winners and the regulators are, once again, patsies, capitulating under pressure to the all-powerful financial industry. The headlines tell the story: “Banks Win 4-Year Delay as Basel Liquidity Rule Loosened,” Bloomberg declared. The Financial Times splashed, “ ‘Massive Softening' of Basel Rules.” “Bank Regulators Retreat,” the Huffington Post said. Reuters described the new regulations as a “light touch.”

Mayra Rodríguez Valladares, a managing principal at MRV Associates, a regulatory consulting firm, put it this way, “With every part of Basel III that is gutted, we are increasingly back where we were at the eve of the crisis.” She went on to say, “In today's financial world, regulators pretend to supervise while banks pretend to be liquid.”

But this is a knee-jerk response.

While there is no question that the original rules would do a better job preventing the next 100-year flood in the banking syste m, their quick adoption most likely would have created their own drag on the economy because bank lending would most likely have been curtailed.

“If Basel had been implemented this year as written, it almost certainly would have thrown the U.S. and other economies into a recession more than going over the fiscal cliff ever would have,” John Berlau of the Bastiat Institute, a research organization promoting free markets, wrote. Mr. Berlau, who may have a penchant for hyperbole, had been calling the deadline the Basel cliff. He added, “Basel III has been delayed, and for Main Street growth and financial stability, that is all to the good.”

Mr. Berlau is right. In truth, the reason that regulators ultimately chose to relax the rules was simple practicality: many banks in Europe and some in the United States would have never been able to meet the requirements without significantly reducing the amount of credit they were to extend to Main Street over the ne xt two years, according to people involved in the Basel decision process.

That's the other side of the regulatory coin that Main Street often forgets about. At the time that the original rules were written in 2010, the consensus among economists was that the global economy would be in much better shape today than it is.

“Nobody set out to make it stronger or weaker, but to make it more realistic,” Mervyn A. King, governor of the Bank of England, explained.

Let's be clear: high capital requirements are a good thing to do to reduce risk in the system. And there is no question that the banks, especially in the United States, are in a much stronger position than they were. Let's also stipulate that the Basel committee did a horrible job before the financial crisis in set ting and enforcing proper standards. Basel's loosening of rules before the crisis that worsened the pain of the global banking system.

But the push for stricter rules just as the global economy is trying to nurse itself back to health, simply to satisfy the public, rather to find a solution that balances the risks to the economy and the banking system, would have been a mistake. The chances of a leverage-induced crisis from Wall Street banks right now is quite low.

The challenge for regulators is making sure their memories aren't so short that they seek to scale back the rules again.