Global authorities have settled on powerful new rules for the world's banks, agreeing to significantly heavier reserves that would impede the impulse to seek profit through excessive risk taking.
Senior regulators from 27 countries agreed on Sunday at a meeting in Basel, Switzerland, that lenders should be forced to retain common equity equal to at least 4.5 per cent of their assets, compared with the current standard of 2 per cent.
On top of that, the governing body of the Basel Committee on Banking Supervision said banks should be directed to add an additional 2.5 per cent buffer so that core reserves, which back everyday lending, aren't reduced during an expected economic or financial shock.
The Basel Committee's agreement on capital is the most significant yet in the international effort to overhaul regulations that not only failed to restrict banks from risky behaviour, but also failed to contain the damage when those institutions pushed too far.
By holding bigger reserves of assets that can be easily sold, central bankers and financial supervisors hope to limit risk taking by forcing lenders to devote more of their profits to stockpiling reserves.
The demand for larger buffers also could bolster confidence in the financial system by easing worries that banks could fail, and reduce the likelihood of future government bailouts.
"The agreements reached today are a fundamental strengthening of global capital standards," European Central Bank president Jean-Claude Trichet, who chairs the Basel Committee's oversight body, said in a statement. "Their contribution to long-term financial stability and growth will be substantial."
Mr. Trichet's group, which includes Federal Reserve chairman Ben Bernanke and Bank of Canada Governor Mark Carney, was under pressure to come up with proposals for a broad overhaul of international financial regulation in time for the next meeting of Group of 20 leaders in November.
Making the deadline was an achievement in itself. The Basel Committee's previous guidelines, known as Basel II, were completed in 2004 after five years of negotiations. Work on the so-called Basel III agreement that will be presented at the Nov. 11-12 summit in Seoul only began in earnest last year.
Bankers fought higher capital standards, arguing that policy makers risked choking the recovery by forcing financial institutions to save money that they could otherwise lend.
The Basel Committee countered with a study in August that said the benefits of a sounder financial system would outweigh any impediment to lending.
Douglas Elliot, a fellow at the Washington-based Brookings Institution and a former investment banker, sided with the regulators, estimating that the higher capital standards being contemplated by the Basel Committee would add only about 0.2 percentage points to the cost of a loan in the United States.
Nevertheless, the banker's argument about the economic impact of new regulations got the authorities' attention. Financial institutions won't face higher capital standards until Jan. 1, 2013, a delay that seems "kind of long" and is probably "where some of the political compromises are coming in," said Eric Helleiner, the Waterloo, Ont.-based Centre for International Governance and Innovation's chair in political economy, who has written several articles about Basel III.
Nor will banks face the full force of the new requirements immediately. The common equity standard will rise to 4.5 per cent in 2015. The additional 2.5 per cent buffer for economic shocks will be phased in between 2016 and 2019. A proposal that would tie the amount of lending banks can do to their assets would come into force in 2018, provided it passes further review.
Canada's banks will benefit from the extended timeline, said Peter Routledge, head of financial services research at National Bank Financial Inc.
While Canada's big lenders are in better shape than many international peers, they still will have build up common equity and other forms of "pure" capital because regulators intend to severely restrict what can be counted for core reserves, a list that currently includes assets such as pension surpluses and deferred taxes.
But unlike lenders such as Deutsche Bank AG, which is working on raising $10-billion (U.S.) in part to meet new capital standards, Canada's banks likely will be able to easily meet the standards by setting aside earnings over the next couple of years. In fact, with the regulatory environment clear, Mr. Routledge said he expects Canadian lenders to boost dividends, make acquisitions, or both in the months ahead. "We are entering a new phase for Canadian banking," Mr. Routledge said from Toronto.
Nancy Hughes Anthony, head of the Canadian Bankers' Association, reserved judgment, saying there remain "important component parts" that are still unknown. For example, the Basel Committee said it intends to recommend even stricter standards for systemically important banks, although it has yet to come up with a definition for such institution s or how they would be asked to enhance their reserves.
The Basel Committee's suggestions aren't binding, and individual countries apply the guidelines as they see fit. However, Ms. Hughes Anthony conceded the agreement is unlikely to change much at the G20 summit. "It will be hard for politicians to challenge the wisdom the authorities on this one," she said.