10/26/2010 10:33 am ET Updated May 25, 2011

Mervyn King: Basel Won't Prevent Another Crisis

Mervyn King, governor of the Bank of England, criticized the recent Basel III requirements, which increase the minimum amount of capital that banks must keep on hand, saying the requirements will not prevent another financial crisis.

Speaking Monday at the Buttonwood Gathering in New York City, King said that despite arguments from the financial sector, the Basel III accords, which require banks to hold 6 percent of their assets in capital by 2019, set standards too low. Should crisis strike, he said, they will not provide an effective buffer.

"It's certainly a step in the right direction. But if it's a giant leap for the regulators of the world, it's only a small step for mankind," King said. "Even the new levels of capital are insufficient to prevent another crisis."

Vikram Pandit, CEO of Citigroup, who spoke after King, took a different view. Like King, he criticized Basel, saying the agreement could "make the problem worse," but he cited different reasons. By focusing only banks, Pandit said, Basel encourages risk elsewhere in the financial system. Non-bank institutions, such as insurance companies, which compose the "shadow banking system," and which don't have to follow Basel's capital requirements, will be able to make riskier trades, a phenomenon Pandit called "regulatory arbitrage." The financial system, Pandit said, could become riskier.

"Remember that the banking system is not synonymous with the financial system as a whole. And Basel only affects the former," Pandit said. "The rules don't cast a wide enough net."

In an argument that directly contradicted King's assessment, Pandit said the capital requirements on banks could turn out to be too high. Due to rules that require banks to factor in risk when calculating their capital levels, Pandit said, the actual required percentage will be higher than advertised. While the lack of regulation on non-bank institutions could increase risk, he said, an excess of regulation on banks could also pose problems.

"There is a point at which more is not necessarily better," he said, referring to capital requirements. "Double-digit ratios will have direct negative impacts on lending, capital formation, aggregate demand and growth."

But King's position challenged the banker's assumptions, as he said the capital requirements are far too low to offer any protection, and that their potential damage to growth is overblown.

"Some of the calculations of the alleged economic costs of higher capital requirements presented by the industry seem to be highly exaggerated," King said.

What's more, the process of adjusting capital requirements for risk, King said, can be murky, as risks are difficult to assess. "If only banks were playing in a casino, then we could probably calculate appropriate risk weights," he said.

Still, King supported Basel's long implementation time line, saying banks shouldn't be forced to raise capital quickly as they're undergoing a process of reducing their debt.

Pandit, for his part, concluded his speech by saying Basel creates a false and dangerous sense of safety. He suggested that policymakers continue the debate on Basel, just as they debated the Dodd-Frank financial reform.

"By creating an illusion of safety, Basel actually dulls the sense of urgency," he said. "In many respects, particularly on higher capital, Basel is headed in the right direction. In other respects, Basel is making the problem worse."