A new regulatory measure fails to address the quality of funds, writes Dr Gareth Morgan, director of Gareth Morgan Investments.

The Basel III Agreement hammered out over recent months and announced a week ago is aimed at protecting economies from the sort of meltdown over 2007-2009 that brought the global financial system to the brink.

It does this by raising the amount of "Tier 1" capital (the definition of which is now tightened to include only subscribed shares plus retained earnings) that banks need per dollar of "risk-adjusted" assets they create.

Previously the ratio was 2 per cent, now it is to be at least 4.5 per cent with stringent conditions in place (prohibition of dividends or payment of staff bonuses) if it is below 7 per cent. On the face of it this seems a substantial response to the meltdown. However banks have until 2019 to comply.

It is expected that the regulators within many of the 27 countries that belong to the Basel agreement on banking supervision will adopt a more stringent approach over and above Basel III.

Some will bring the regime in sooner (the US) while others will beef up the conditions on pay and bonus regimes (the UK). Another provision that will be left to individual member countries to decide upon is a cyclical component of the ratio that could add up to a further 2.5 per cent to the ratio of Tier 1 capital required.

While ensuring a lending house has to risk more of its own capital to the quality of the lending decisions it makes will not unambiguously temper the excesses of recent years, because it's that definition of the quality of assets that, despite Basel III, remains the biggest system threat.

Whether guidelines on the risk weights to use issued at the Basel level, or as modified for national jurisdictions, accurately reflect actual risks, is a subject Basel III has not addressed.

Clearly it is the case that previous guidelines on risk weightings were just rubbish - banks got deeply into SPVs, derivative netting, and repos - all of which crumbled and dragged financial houses down with them during the recent crisis. From there it became a headache for taxpayers as financial houses "too big to fail" ensnared governments.

Unless the quality of assets is addressed by the reforms of banking supervision then we cannot say that the regulatory response has been adequate to protect taxpayers from once again being the ultimate guarantor of the profligate, underwriters of depositors and other creditors of fast and loose financial houses.

The moral hazard remains - those who know that they are too big to fail will continue to take undue risks, it's just a matter of time. Sure, it just became a bit more expensive perhaps - although so variable is the Tier 1 capital ratio around banks of the 27 member countries that in fact the new 7 per cent ratio is already exceeded by many in systems that "failed" over 2007-2009 anyway. So little comfort can be gained from the regulatory response of Basel III.

Further, a "crisis" is not the only indicator of a poorly performing banking system, rather it is the culmination of failure, failure that can be many years in the making. Even more depressing for taxpayers is that regulatory inadequacy can be manifest in failures well beyond those institutions directly under the charge of the central bank.

Take New Zealand for example, where taxpayers have been called upon to bail out depositors, not at the banks directly under the Reserve Bank's prudential supervision, but rather finance companies that to a far greater extent lie beyond Reserve Bank rules and regulations.

Yet their failure and the subsequent impost on taxpayers can and should be directly sheeted home to Reserve Bank regulatory inadequacy. According to the Reserve Bank at the time, the guarantee for finance companies had to be introduced to prevent a flight of deposits from that sector.

In other words the remnant of that sector, although significantly battered at the time that Alan Bollard made his declaration, was "too big to fail". The central bank was, in other words, assuming responsibility for those finance houses at that point.

It's illogical to assume it wasn't always going to do that if such circumstances arose. In other words, the more lax supervision over non-bank financial houses that preceded the Bollard pronouncement, was a charade. If push came to shove the Reserve Bank would call on the taxpayer to foot the bills.

Herein lies the core of the 1990s disease that prevailed, not just through the commercial banking world, but the roots of which can be sheeted fairly and squarely back to central banking, and its most shameful decade of negligence. There was, obvious to us all at the time, a speculative bubble centred around the property market.

Many of us wrote a lot about it at the time. It was recognised and publicly commented upon by Reserve Bank governors in New Zealand too, but the extent of their reaction was limited to hand-wringing, asinine increases in the OCR so that interest rates across the board rose, punishing all forms of borrowing not just mortgages. Indeed throughout the period, the directive to banks remained - treat lending on mortgage more favourably than any other form of lending.

The discussion in policy circles was that asset price bubbles should not be the target of monetary policy. One could certainly empathise with that view but it didn't follow at all that they shouldn't be the target of prudential supervisory policy, another role central bankers get paid for.

The favoured status of property lending in terms of (the low) risk-weighting the commercial banks afforded it, continued (as it does to this day). So really our central bank sat there like a big dummy, waiting for the inevitable. And meanwhile the economic cost of those years of negligence was material - funding denied other sectors, sectors that created jobs and income but were not on any sort of level playing field getting access to funds from the (taxpayer underwritten) banking sector.

What a surprise, we continued to slip down the OECD league of income earners.

Then when the contagion from the sub-prime crisis reached New Zealand, we were plunged into our own version of it. The finance companies whose loans were stacked above those of the banks into the property speculative orgy, were the first to have their funding tightened.

Already several of these companies had turned to dogmeat, their domestic depositors and debenture holders in ruins. Australia moved to guarantee its banks and our Reserve Bank by then had no choice, do the same or suffer capital flight, particularly from foreign depositors.

A quick assessment confirmed what we all knew, that the remaining finance companies were all caught in the same vortex, funds outflow would finish them off. The Reserve Bank guaranteed their depositors.

The property boom in New Zealand has been one of the biggest internationally and its consequences are yet to play out fully. The blame lies squarely on the shoulders of successive Reserve Bank governors who recognised the blight but suffered paralysis or brain fade under fire, resorting to monetary policy rather than prudential supervision to sort it out.

The damage caused to the economy over many years was inexcusable, the bills still mounting for taxpayers just one manifestation of inadequate stewardship of the central bank.

And now Basel III doesn't really address the issue of risk weighting given to various assets the banks create, rather it merely says they should carry more shareholders funds.

The increase recommended provides little effective tightening on New Zealand's foreign-dominated banking system anyway, and it remains instructed to favour property over all other forms of lending. The supervisory negligence lives on to materialise another day. Pity the taxpayers that have to underwrite such inadequacy.