Banking on Basel III?

Profs. Jaffee and Walden find regulatory reform is almost a wash.


Prof. LevineThe new regulatory banking standards called "Basel III" slightly decrease but do not eliminate systemic risk in the banking system, according to research by Professor Dwight Jaffee and Assistant Prof. Johan Walden.

Furthermore, Jaffee and Walden find that successful mortgage markets in Western Europe provide useful models for mortgage reform in the U.S. Because these healthier markets do not contain public lenders such as Fannie Mae and Freddie Mac, Jaffee proposes the elimination of Fannie Mae and Freddie Mac as a critical step toward healing the domestic economy.

The Financial Markets Committee in Stockholm, Sweden, commissioned the study of Basel III, which is a framework of global regu-latory standards aimed at making the banking system more resilient and therefore more resistant to systemic risks. Jaffee, co-chair of the Fisher Center for Real Estate and Urban Economics, and Walden sought to understand the effects of Basel III on consumer lending rates and determine whether the regulatory standards would mitigate systemic risks that caused the 2008 financial crisis.


In their report, The Impact of Basel III and Solvency 2 on Swedish Banks and Insurers—An Equilibrium Analysis, Jaffee and Walden determine the banking and insurance regulatory reforms produce minimal effects—at least in Sweden.


"It is not going to have negative effects but it is not going to make sig-nificant positive differences either," says Jaffee, who argues the findings for the Swedish economy are important to the U.S. economy. "The U.S. financial systems remain highly exposed to a future systemic crisis, and looking to other economies, like Sweden's, may be helpful."


Jaffee and Walden forecast that Basel III will influence borrowing rates and gross domestic product growth by less than one percent.


"Banks will have higher capital ratios, which measures how much equity the bank has compared to how much debt. A higher ratio leads to lower risk, but it might also lead to higher borrowing rates for customers because swapping debt into capital reduces the tax shield benefit of the debt," says Walden. "When we did the numbers, it just came
out that the effect in terms of raising interest rates and reducing GDP growth will be very,
very small."

Because new regulations will be implemented over a long period of time (through 2018), any "supply shocks" on bank lending will be minimal, the pair finds. Also, the new regulations do not completely eliminate the key sources of systemic risk for Sweden's small open economy, namely, mortgage risk and the inevitable influences of changes in the global economy. Finally, as Swedish banks and insurers pass increased costs to customers, customers will seek alternative financial suppliers, supporting an expansion
of new markets—a positive result, the researchers conclude.

"Basel III does put in some additional requirements concerning mortgages and how they would be treated by the banks. And I hope that as the U.S. reforms our mortgage market, regulators will take that into account," says Jaffee.

"Fannie Mae and Freddie Mac have proven to be a serious detriment to the U.S. mortgage market," Jaffee adds. "We need to remove Fannie and Freddie and build up a regulatory structure that anticipates a greater volume of mort-gage lending going through the banks. You need strong Basel III requirements and very good regulators overseeing it."


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