As the Christmas period approaches, Regulation Asia contributor Jamie Lloyd Evans offers a light-hearted prediction on the future of the Basel Accord.

From the 17th century, astronomers have been observing a type of star whose brightness continuously changes with a very high degree of regularity. These stars grow brighter and then dimmer, and then brighter and dimmer again, on what seems like a time loop.

The stars are called cepheid variables and our understanding of their behavior advanced significantly in the early 20th century when Henrietta Leavitt began to take detailed measurements of their brightness (or luminosity) and the length of time (or period) between each variation. Leavitt’s observations would eventually contribute to the measurement of distances outside of our galaxy for the first time in modern astronomy.

The observed variability is generally attributed to a lack of stable equilibrium in these stars – unlike our own sun – which means that they heat up very quickly through the activation of a process of nuclear fusion, but then take a longer time to cool down. As they begin to cool down the stars collapse inwards due to the force of gravity, but at some point the compression becomes so great that it unleashes a new wave of nuclear fusion; hence the process of heating and cooling runs its course over and over again. If we were to illustrate this pattern of behaviour by plotting the magnitude of a cepheid’s luminosity against time, the graph (or the ‘light curve’) would look like an asymmetric wave – or a repeating shark’s fin.

Using the cepheid light curve as a model for changes in financial regulation over time, we attempt to apply this approach to the Basel Accord. The method is based on limited historic observations, but assumes that an asymmetric pattern of tightening and loosening is intrinsic to the nature of regulation.  If we are able, therefore, to establish the period of variation we can then make certain predictions about the nature and timing of the next iterations of the Basel Accord:

1988: Basel 1

2004: Basel 2

2010: Basel 3

2026: Basel 4 [1]

2032: Basel 5

These outputs are based on a perceived pattern of heating up and cooling down of the Basel framework on a periodic basis, in the same way that the luminosity of a cepheid increases and decreases alternately. The wavelength of the Basel Accord is estimated to be 22 years[2] based on the actual length of time between Basel 1 to Basel 3 (peak to peak), and during this period, we observe a cooling duration of 16 years (from Basel 1 to Basel 2) and a heating duration of 6 years (from Basel 2 to Basel 3).

During times of heating up, relatively more stringent capital requirements are introduced combined with a lower degree of confidence in the market’s ability to self-correct for excesses. Conversely, neutral or relatively lower capital requirements during cooling periods coincide with a higher degree of confidence in the role of markets.

The heating-up period of 6 years is observed to be shorter than the cooling period of 16 years on account of a greater urgency (nuclear fusion) to correct for financial excesses; consequently, the cooling period is almost 3 times as long.

Accord

Requirements

Role of Markets

Duration

1988

Basel 1

Heating

Weaker

2004

Basel 2

Cooling

Stronger

16

2010

Basel 3

Heating

Weaker

6

2026

Basel 4

Cooling

Stronger

16

2032

Basel 5

Heating

Weaker

6

We regard Basel 1 as a heating phase as it sought to address concerns that certain banks that were active in the international syndicated loans market were undercapitalized. The Accord therefore introduced minimum capital requirements amongst the G10 countries to increase the overall level of capital in the system address perceived market distortions.

We view Basel 2 as a cooling phase because the Accord did not intend to increase aggregate capital levels in the banking system, but principally tried to reflect advances in risk quantification and management in the industry, and improve the granularity of the Basel 1 capital requirements.

Basel 3 is regarded as a heating phase as it intentionally increased capital requirements in response to the GFC, and introduced a number of additional measures such as the liquidity and leverage ratio requirements.

Based on this paradigm, a complete revision of the Accord (Basel 4) is predicted to take place in 2026 as the culmination of a cooling phase. This output may seem implausible given the timeframe, but we would point to potentially supportive evidence of cooling that is both intrinsic and extrinsic, for example:

• peak bank liquidity and capital (likely achieved during the Covid pandemic);

• political rehabilitation of banks (post GFC);

• protracted low-growth environment; and

• persistence of financial innovation and activities outside of the regulatory perimeter.

This evidence is circumstantial and due to its judgmental nature is necessarily open to challenge. However, cumulatively it may provide – if not, a rate of change – then directional support for the 2026 output.

The cepheid paradigm then forecasts an overhaul of the framework (Basel 5) that would be undertaken in 2032. Given the timespan, we can cite little or no evidence to support this outcome. However, based on a regular pattern of variability it may be reasonable to assume that the revised framework will represent a response to systemic excesses that have been built up following the introduction of Basel 4, for example the timeframe may suggest rapid and widespread adoption of nascent technologies that are being developed through public and private initiatives.

Caution should be exercised with these outputs as the cepheid paradigm is based on a very limited number of observations. However, the validity of this approach will ultimately be determined by its predictive capabilities. Its failure to make accurate predictions may indicate a challenge to the model calibration or possibly a change in the behavior of the star that results in a prolonged cooling period. In either case a substantive failure would likely encourage the development of competing models that could introduce entropic conditions.

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Leavitt’s breakthrough discovery was an observation that a direct relationship existed between a cepheid’s luminosity and its period of variation, as illustrated in her original 1912 paper[3].

This meant that the stars with the shortest period of variation also had the lowest brightness, while those with the longest period of variation shone the brightest.

At the time of her discovery Leavitt was already deaf due to an earlier illness, and her work was undertaken on the basis of photographic plates as she was not permitted to operate a telescope. She died in 1921 before her contributions to astronomy – or financial regulation – were widely recognized.

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Disclaimer: all references in this article to models that relate to banking regulation are more or less entirely spurious

[1] Despite the language used by industry consultants to describe Basel 3 modifications, ‘Basel 4’ has certainly not yet arrived, according to the BCBS

[2] Longer-period cepheids are estimated to vary over periods up to 180 days, hence our observation of 22 years is analagous in only a very loose sense

[3] Periods of 25 Variable Stars in the Small Magellanic Cloud, Leavitt & Pickering (1912); the two data series in this graph represent maximum and minimum luminosity of a group of cepheids plotted against their period of variation (horizontal axis) on a log basis

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Jamie Lloyd Evans is a seasoned financial services practitioner who has experience as a banker, regulator, and advisor in the fintech space.