Why Basel III will not prevent the next crisis

What progress have we achieved in solving the worst crisis the world has suffered since the Second World War? Can we prevent the next crisis?   

The first thing we have to admit is some humility. The best and brightest of Western minds did not see the last crisis coming, and none of us can predict when the next crisis will happen. In fact, three events this year were not even on our radar screen last year, but anyone of them could change the course of history – Ukraine, ISIS and Ebola. These are all “butterfly events” that can cause global chaos, because we all live in an increasingly crowded and interconnected world. 

The second is to admit the flaws in the scientific paradigm we use to think about the world and to offer solutions. We got into trouble because we used models and theories that assumed the future could be predicted by historical data in a linear, mechanical projection. It reminds me of the pilot’s adage that “those who fly by black boxes die by the black box”. If the radar cannot read the air turbulence ahead, we fly straight into the storm.

The scientific paradigm that we all use today is to take a total problem, break it down into parts and then study each in depth, so we know more and more about less and less. We forget that we all live within complex systems, with the parts totally interconnected and interacting with each other in non-linear complex ways. Since we live in systems within systems, because we are all in a highly crowded world, the complexity is not only increasing but becoming more unpredictable and unmanageable by the day. 

California systems thinker Fritjof Capra, who broke new ground with his books “The Tao of Physics” (1975) and “Web of Life” (1996), has just written an undergraduate textbook with Italian Professor of Biochemistry Pier Luigi Luisi called “The Systems View of Life”. What they argue is that the current Newtonian scientific worldview is mechanical and outdated. What we need today is a worldview that “evolution is no longer seen as a competitive struggle for existence, but rather as a cooperative dance in which creativity and the constant emergence of novelty are the driving forces”.  

Life is actually not just a cooperative dance, but also a war dance, because the emergence of the Ukrainian conflict, ISIS terrorism and spread of Ebola are all about geography and power. What Capra and Luisi suggest is that we need a new science of qualities that forces us to think in terms of relationships, patterns and context – namely, “systems thinking”.  

In other words, we all live in different systems that are dynamically changing, interacting dynamically with other systems, so we must always seek to understand the world in terms of relationships, patterns and context.

This brings us back to the question of whether preventing the last crisis will prevent the next one? The Basel Committee on Banking Supervision, the global standard-setting body on bank regulation, has been expanded to include more emerging market members. This week, it announced the inclusion of Malaysia, Indonesia and Chile as new members. It has worked very diligently to identify the causes of the last crisis and to fix them through a whole raft of new rules.

But if the past is not necessarily the best predictor of the future, then fixing past problems is a necessary but not sufficient condition for preventing the next crisis. Hence the need for some humility in what can be achieved by adding more and more complex rules.

Understanding relationships, patterns and context is ingrained in the Eastern way of thinking. We live in complex human networks that are always dynamic and changing, interacting not only with each other, but with Mother Nature. Ebola is a new bug seeking to evolve, and spreading as human beings spread around the world. ISIS is also a non-state actor that rose from the ashes of conflict in the Middle East, with increasing global reach through the Internet. There is a pattern in these seemingly random events. Life is not completely random.

Ukraine, Ebola and ISIS are not directly connected with banking, but they will have huge impact on banks, because they can disrupt real activities. Banks account for half of the global financial assets, and the war efforts in Ukraine and by ISIS are funded through banks or underground banks. Ebola may take over $1 billion to fight and control. And while we are fixing banking through Basel III, the whole context in which banks operate is being changed, by technology giants such as ApplePay (through the iPhone 6) and Alibaba.

The global financial crisis affected banks badly and was partly blamed on shadow banks. But this current generation of policymakers keep on trying to find the key under the lamp-post where there is light, rather than looking in the shadows – where real activities are being driven by more and more regulation. Perhaps the solution is to improve the coverage of the light, but also to understand that more and more specialised bank regulators cannot solve global problems on their own. We need to cooperate together to solve such problems.

We live in a world of increasing polarisation and contrasts. The world is slowing down, but there is huge liquidity around with bubbly markets, though that is only for the rich and powerful. The world is not short of credit. It is short of equity in both senses – of more capital to cushion unknown risks for the 99 per cent, and more fairness in the system. 

That is something outside the remit of bankers and bank regulators. So, I humbly submit that Basel III will fix some of the problems of yesterday, but not the crisis of tomorrow.

 

Andrew Sheng is a former financial regulator.