The Federal Reserve should extend its recent rebuke of the Basel Committee to the entire enterprise. The Basel Committee on Banking Supervision emerged as the international community's response to the inadequate financial regulatory frameworks globally that had contributed to the great financial crisis. The Basel Committee is charged with setting standards for bank regulation. Though its standards are nonbinding, members frequently endeavor to implement them through their domestic regulatory processes, as seen in the current fight in the United States over the implementation of the so-called Basel III Endgame.
The Basel Committee suffers from the same tendency as all international organizations: a need to continually justify its existence according to the politically salient issues of the day. And there is no trendier issue in central banking than climate change, which a number of major central banks have incorporated into their mandates. Amid intense international interest, particularly from the European Central Bank, the Basel Committee has pursued a broad agenda to weave climate change into its recommendations on regulation, supervision, and disclosure.
Yet the Federal Reserve and other U.S. regulators appear to have delivered a rebuke to these efforts. Recent reporting suggests that the Fed succeeded in persuading the Basel Committee to not incorporate climate change into its regulatory recommendations and to cut back a range of other climate-change initiatives related to supervision and disclosure. The Fed's shift is particularly notable given that, in recent years, the Fed itself has followed the trend set by other central banks by incorporating climate change into its work. This involvement went so far as to have an official from the Federal Reserve Bank of New York co-chair the Basel Committee's Task Force on Climate-Related Financial Risks. The Fed deserves credit for recognizing that climate change lies beyond its mandate and wisely concluding that work on political issues threatens central-bank independence. It should stay this course and focus on its narrow mandate by leaving the issue of climate change where it belongs – in the hands of Congress.
Having taken this action, the Fed should extend its turnabout more broadly to the work of the Basel Committee, which is fundamentally unsuited to promoting financial stability in the United States.
The premise that a group of international technocrats can apply sufficient skill to anticipate ever-changing risks and somehow safeguard financial stability is mistaken. The future is inherently unknowable, and regulation for both domestic and foreign banks should embrace this simple truth by setting clear, simple, and rigorous standards for capital and liquidity risk that promote the resilience of the banking system when the inevitable losses arise. But the Basel Committee's legions of economists are instead incentivized to justify their existence by using their considerable skill to build highly complex models and regulatory standards. Their work product necessarily reflects their assumptions about an unknowable future, which by definition will be proved wrong. This dynamic obscures the actual risk in the system: Silicon Valley Bank ended up technically insolvent because of losses on its government-bond portfolio that the Basel-conforming risk-weighted capital system had deemed safe.
Highly complex rules developed in Basel threaten the financial system. The intricacies of the rules create substantial opportunities for banks and other financial institutions to game the system by lobbying for privileges and engaging in regulatory arbitrage. Additionally, the extent of the regulatory burden creates significant barriers to competition from new market entrants, increasing the concentration of the system and reducing its dynamism. Paradoxically, increasingly prescriptive rules developed by Basel technocrats tend to increase the fragility of the system because financial institutions respond in the same manner to regulators' assigned risk categories. When the inevitable shock comes, banks that have been directed to do the same thing fail in the same way, resulting in systemic failure.
The history of the Basel Accords suggests that even when agreements are achieved, countries interpret rules differently to serve their self-interest, as seen in the disparities in bank-capital levels among countries. Rather than continue the charade in which domestic regulators use the Basel Committee's pronouncements as both a sword to buttress their own agendas and a shield to avoid accountability, countries should set their own prudential standards – and institutions that wish to operate within their borders should be subject to them. We suspect that, over time, outcomes would favor those countries with the clearest and most balanced standards in the pursuit of financial stability and economic growth.
Thomas Hoenig is a distinguished senior fellow at the Mercatus Center. Dan Katz is an adjunct fellow at the Manhattan Institute and served as a senior adviser at the U.S. Treasury in 2019–21.