Image: U.S. currency © Steve Allen, Brand X, Corbis

What comes after QE2?

Who will pick up the slack after the Federal Reserve ends its second program of quantitative easing at the end of June and stops buying $75 billion in U.S. Treasurys every month? Not exactly a minor question for a country running a national debt of $14.5 trillion.

The answer, investors fear, is no one. That would lead to an increase in U.S. interest rates -- if the market found buyers at all, they would ask for a higher yield -- just when the U.S. economy is slowing. The worst-case scenario would be that some delay in raising the debt ceiling would create a technical default at precisely the time the Fed exits the Treasury market. That could lead to a spike in U.S. interest rates rather than a more gradual increase. A spike would doom any chance for a recovery in the housing market and lead to massive losses for anyone holding a portfolio of Treasurys.

At least that's how the worry goes.

I've been racking my brain to find another answer. I think QE3 is off the table. The Federal Reserve isn't about to take on the financial and political risks of adding a half-trillion or so to its balance sheet, which has climbed to $2.84 trillion as a result of the central bank's battle against the effects of the global financial crisis.

But recent decisions by the regulators drawing up the new Basel III rules for the global banking system point me to a new alternative to the disaster scenario markets see for the Treasury market.

image: Jim Jubak

Jim Jubak

Basel III will ride to the rescue

Basel III? Yep, I'm referring to the bank regulation scheme more complicated than Ptolemy's astronomy and much less likely to work as predicted. I don't know that I'd call Basel III a rescue plan for the developed world's central banks -- the Federal Reserve, the Bank of Japan, the Bank of England and the European Central Bank -- because I don't know if the regulators (including central bankers) who put together the rules intended to rescue central banks. The rescue may just be an unintended consequence of the new regulations.

Intended or not, plan or side effect, Basel III does promise to "solve" central banks' big balance sheet problems -- for a few years anyway.

Let me show you how this is likely to work and then run through some of the dangers that this "solution" creates.

Basel III, the aptly named successor to Basel II, is an attempt to make the global banking system less susceptible to a replay of the global financial crisis that took Lehman Brothers and Bear Stearns into bankruptcy; threatened to take down American International Group (AIG, news), Citigroup (C, news) and a handful of European banks; and almost led to the collapse of the world's financial system.

As part of that solution, banks will be required to show a higher Tier 1 capital, or core capital ratio, than before the crisis. The theory is that banks with more capital will have bigger cushions to fall back on in the event of a crisis. The core capital ratio under Basel II was set at 4%. Under Basel III, the base core capital ratio will climb to 7%.

The rules also set up capital surcharges for the 30 banks in the world that regulators have deemed systemically important to the global system as a whole. These banks have been divided into categories, with the surcharge beginning with 1 percentage point and climbing to 2.5 percentage points. There's even an empty category with a 3-percentage-point surcharge for banks that in the future exceed today's top-tier banks.

How do regulators decide which banks go in which categories? A combination of factors includes regulators' judgments on how important the bank is to other banks, the degree of a bank's cross-border business, its own sources of capital and the risk of the bank's portfolio of assets.

In fact, all of the Basel III core capital ratios -- even the starting 7% -- are adjusted for the degree of risk in a bank's portfolio of assets.

And this is where Basel III turns into a rescue plan for central bank balance sheets.

The riskier a bank's portfolio is, the more capital it will have to raise. Capital isn't cheap for banks right now, because the financial markets don't much like the effect of changes in bank regulation on future profits. The more capital a bank has to raise, the lower its return on capital is likely to be. And the less investors will pay for its stock.

But as we all should remember from the global financial crisis, when AAA-rated mortgage-backed securities suddenly turned out to be extremely risky, judging the risk of a portfolio asset isn't totally objective. And in their regulations on risk, Basel III regulators have decided -- so far at least -- that government debt securities will remain, as traditionally, risk-free.

Yep, despite the fact that the debt-rating companies have warned that they've got an eye out for a possible downgrade on U.S. and U.K. debt, and despite recent, even stronger warnings on Italy and Spain, and despite multiple downgrades for Greece, Ireland and Portugal, under Basel III rules, a bank that holds sovereign debt won't be required to adjust its core capital ratio higher to make up for any extra risk.