“He is the problem.” the investment banker said on a sunny afternoon some weeks ago over a plate of Shed 5 fish & chips. I agreed, it’s the governance of the process, or the lack thereof, that puts the capital plans of the Reserve Bank at risk.

The investment banker had spent the entire Christmas break perusing the literature on bank capital, from Steven Ongena to René Stulz to Anat Admati. We met for lunch to discuss.

“But if he is the problem why don’t you study A Theory of Yes Men by Canice Prendergast, or What’s really wrong with bank supervision by Daniel Davis.”

“Just saying”, I continued, “if governance is the problem, then you are wasting your time on studies about optimal capital ratios, because few people at 2 The Terrace may listen, if any at all.”

Fear, greed, and a pinch of vanity

I leave it to you to figure out who “he” is, or if it is only one “he” or perhaps two, or maybe a “she”. That’s besides the point. The issue is, as usual, a combination of incentives and governance. The incentives in this case are fear and greed, pictured below. These are all too powerful and can wreck organizations, if left ungoverned.

The proposal is the brainchild of one Reserve Bank official in particular. Someone who apparently is afraid of ever-growing regulation and the inability of the Reserve Bank to keep up. The end result is as simplistic as it is Trumpian: Let’s build that high wall of capital, let’s establish that high floor. Let’s get rid of concepts that we do not master: the IRB approach and CoCo’s. Let’s ignore Basel III, reinvent the wheel, and make New Zealand’s banks great again. Project fear is now well underway. Once the higher capital requirements have entered into force, the RBNZ official will be promoted. Having worked at a reserve bank myself, I expect no colleague to challenge that promotion. It’s how these things work in practice.

Whether it is a well-deserved promotion remains to be seen. Time will tell. But to give you an idea of the proper approach to addressing the complex task of rewriting bank capital rules, I invite you to a view on the governance of Basel III first.

Basel III: the result of teamwork

The great thing about Basel III is that it is not really a response to the GFC. If that were the case, then it would have taken the Basel Committee of Bank Supervision much more time to craft the post-crisis rules.

Just look at the timing of events: In April 2009 the G20 decided this:

In less than eight months, Basel produced a comprehensive document that includes a fresh recipe for capital: the Resilience document emphasizes the role of Common Equity and it presents a simplified Tier 1 and Tier 2 structure. It also introduces a conservation buffer and plans for a leverage ratio – all internationally harmonized. Isn’t that exceptionally fast?

Speed is your friend

How did the Basel Committee write a comprehensive capital plan in such a short time? I mean, the European Basel Committee members are on holiday from July to end of August. The document had to be ready by November for the top-level Basel Committee meetings. So, the group that wrote the document must have worked flat out during April, May, June, September, and October. Or, which is much more likely the case: there was already a group working on Basel III.

It was the latter, Basel III was the sequel to Basel II, which was done and dusted by 2006 and had entered into force. Work on Basel III had begun as early as 2007.

No prima donnas to be seen here

By April 2009 there was a fully functioning team, ready to respond to the call of the 2009 G20: write rules that improve the quality and quantity of capital. For some time, I was member of that team. We worked diligently to overcome differences and find solutions for problems big and small. The team reached out. It invited stakeholders and experts to inform the process.

Moreover, the Basel Committee takes decisions by consensus, which means that each member can ‘veto’ decisions until consensus is achieved. In a relatively short time the team found solutions for capital of co-operative banks, for Italian DTAs, Australian “stapled instruments”, and the capital (in)eligibility of German Silent Partnerships.

Most of the time however, we spent on creating an instrument that would absorb losses in going concern. So, yes, it took years to reach consensus on a minor issue: the trigger that leads to conversion of Additional Tier 1 instruments. Should the trigger be high (7%) or low (5.125%)? In the end we chose the latter, see the FAQ of December 2011. Apart from that, many of the other items of the Basel III rules text were quickly decided.

Basel succeeded in the end in developing a term sheet for CoCos. Spanish banks Popular and just this week Santander demonstrate that these instruments perform largely to specs.

The importance of proper governance

By now you should understand the importance of governance. Basel III is not the brainchild of one person, it was the result of a well-governed multidisciplinary team which worked out how to complete the task set out by the G20 countries. Most of the team members were selected before the onset of the GFC on the basis of expertise. We worked at supervisors and represented the Basel member states, which introduces a form of accountability. Decisions were made on the basis of consensus, not on the basis of simplistic mantras, fear, or greed.

On top of that there is a comprehensive system of checks and balances. A consultation process to start with. Then, twice per year the Basel Committee publishes a monitoring report to check if member states are on track with improving the quality and quantity of bank capital. There is also some naming and shaming, the Regulatory Consistency Assessment Programme RCAP.

Lastly, countries implemented Basel III by way of laws, which introduces additional accountability.

I do not remember the Basel Committee posting a trove of internal documents on a Friday afternoon web-page. Or updates because the original document contains typos. Neither did the Committee go public impromptu to announce capital plans in picture format to “clarify” the speech of a Deputy.

Is that all there is?

Unlikely. Bank supervision is not only about floors, CoCos, or capital ratios. It is also about Pillar 2: capital requirements that are bank-specific and at the discretion of the supervisor.

Bank supervision is also about resolution: one cannot discuss the (in)adequacy of CoCos and at the same time rely on only Open Bank Resolution. The Reserve Bank should take a leaf from the European resolution directive, BRRD. It is a comprehensive toolbox that includes bail-out (!) as well as the tools shown below.

But more on this later.