Saturday, 18 December 2010

More on the lunacy of the Basel Accords

I was looking at the preferred asset classes under the Basel Accords in my previous post on why central banks are so determined to stave off a government default, and realised that every single asset class that is given less than a 100 percent credit risk weighting is now tainted by widespread default, scandals or bailouts.

The credit risk weightings mean that instead of reserving the standard 8 percent of capital in respect of a debt, the bank can cut that by the weighting applied to the asset class. Effectively, the reduction in credit risk weighting operates as a powerful subsidy to the borrowers and equally powerful incentive to over-leveraging the lenders.

As a baseline, all financial, consumer and corporate debt must be reserved at a credit rating of 100 percent of 8 percent, unless explicitly discounted. A weighting of 50 percent, for example, means that instead of holding $8 reserves on a loan of $100, the bank only needs to hold $4 of reserves. A zero weighting means they lend $100, but hold no reserves at all.

Mortgages get a credit risk weighting of 50 percent, and we all know how well the mortgage market is performing. Mortgages and mortgage backed securities became the largest asset classes globally in a matter of years thanks to the credit weighting subsidy and securitisation. If I recall correctly, our present long crisis started with the collapse of the sub-prime market and now all categories of US mortgages are impaired by the ongoing mess with MERS and fraudulent or missing documentation. Borrowing short to lend long brought down Northern Rock in the UK and many other over-leveraged mortgage banks.

Interbank debt gets a credit risk weighting of 20 percent. We've seen from the collapse of interbank lending that banks do not trust each other. At the same time, inter-bank exposures and credit derivatives mean that financial institutions are massively dependent on each other, such that bailouts are justified as essential to prevent systemic collapse. If Too-Big-To-Fail is predicated on the systemic impact of a bank's failure on other banks, it would seem that the 20 percent inter-bank risk weighting was and is unsound.

Government agency debt gets a risk weighting of 10 percent. Looking at Fannie and Freddie, and the serial scandals and bailouts they have occasioned over the past decade, it is hard to see how such a subsidy can be justified.

Finally, sovereign debt of Zone A states is zero weighted - no reserves required at all. Zone A includes any country in the EEA, full members of the OECD, or states that have concluded special lending arrangements with the IMF except that any state that reschedules its debt is excluded from Zone A status for five years.

So the current financial crisis started with bad mortgage debt, spread to bad bank debt, carried over into bad agency debt, and now encompasses bad sovereign debt. Each of these categories was given preferential capital weighting under the Basel Accords, and now all are open sores on the financial system and the stability of excessively indebted governments.

Not only did the Basel weightings encourage poor risk assessment, they directly contributed to the inadequate capitalisation of banks for the risks they assumed.

And yet, have you heard any regulator take responsibility for regulatory failures yet? I haven't. In fact, I've seen no historic analysis of capital requirements, deregulation of credit markets, securitisation, derivatives, demutualisation, or any of the other regulatory policy innovations which should reasonably be matters for review in assessing the causes of the current crisis.

As the bankers and regulators do not seem keen to be reflective about their own policies and conduct, it's hard to imagine that they can craft constructive reforms to make the system safer or more efficient in future.

I've downloaded the draft Basel Accord III, released this week, for leisure reading. Sadly, I'm trending to the view that all harmonised regulation is likely to end in disaster as it precludes independent judgement and sensible challenge to orthodoxy. Once something has been agreed by a big enough committee, it becomes impossible to question whether it makes sense. Ultimately the unintended consequences of incentives and distortions mean it won't make sense, but by then it's far too late to change course and break from the herd.

27 comments:

Nic said...

LB,

Thank you for clarifying the 100% weighting, being 100% of 8%.

Neophyte that I am, I assumed that 100% coverage for corporate lending was stiff, but about right in these times.

Lunacy is the only word. Thank you.

phorgyphynance said...

Have you heard of Solvency II?

Deja vu all over again.

Derek Kite said...

Do I have this right? They can lend any amount with no reserves to other Zone A sovereigns? So in real terms, what would limit the amount of money a bank could lend to a Zone A country?

This explains everything about Europe and the events of the last 2 years.

Derek

idoc said...

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idoc said...

YES, i remember you London Banker. you were highly regarded and i'm sure will be so again. very glad you're back online.

Charles II said...

Glad to see you back, LB, and thanks for the post, but it is B-a-s-e-l.

--The Spelling Police

London Banker said...

@ Nic, you are very welcome. I appreciate that capital ratios are a bit of an acquired taste.

@Idoc, Phorgyhynance, Derek - yes, indeed.

@CharlesII, "Basle Accord" was the original usage. Being Switzerland, there are at least three correc spellings for any city name. I prefer the Anglo/French spelling ("Basle") to the American/German spelling ("Basel").

Wolf in the Wilds said...

Welcome Back LB,

Its been a while. Good to have another sane person back in the blogsphere. Loads have happened over the last year or so. Looking forward to more discussions on the world and the mess that is the banking system.

Anonymous said...

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Anonymous said...

Although Switzerland often has three - or more - official spellings for city names, Basle is not one of them. (Basel, Basilea, Bâle)

Basle is just an anglicisation of the last of these. In English language materials related to Basel (the town AND the banking stuff), the spelling is Basel. Basle looks a little antiquated now. It may be the original usage, but it isn't really in use any more, particularly not with Basel III. I'd go with The Spelling Police's suggestion.

London Banker said...

Okay. I yield. I've changed all spellings of Basle to Basel in this post and the previous post.

Sean said...

http://onlinelibrary.wiley.com/doi/10.1111/j.1467-6419.2009.00590.x/pdf

I think this funny "10 Commandments For Managing Basel II" - written as a parody - exposes a lot of flaws in terms of gaming bank leverage, at the margins at least.

"The Basel II Accord does not penalize excessively large violations, as the penalty structure is intended only for too many violations. If an investor is going to violate, then the violation should be serious (meaning huge)."

But I guess the more salient reason behind ridiculous leverage and overallocation to certain sectors (governments, agencies, mortgages) were the inputs themselves (0% risk-weighting for governments, 10% for agencies, etc.). But I know most of the big banks use the internal-ratings approach.

Of course, I'm sure a lot of the inputs for the "internal-ratings approach" which drive banks' internal models come from the Basel II risk weightings. Would love some commentary on how banks came up with the inputs for these ratings, and how much capital they have to reserve against each "rating tier". How does this differ from the standard Basel II risk weightings?

Anonymous said...

Any chance you could share your thoughts on whether/how Basel III addresses the regulatory/capital arbitrage opportunities that Basel I and II gave rise to. By that, I mean Banks using Credit Derivatives (a la AIG), Securitization or Total Return Swaps to reduce the amount of Reg Cap that they have to apply against their assets by entering into such transactions with different counterparties (e.g. pension funds, hedge funds, and I guess some insurance cos!)

Dan said...

LB,
Forgive my ignorance.
I wonder if you can comment on my understanding of one aspect related to the FED.

The FED is privately owned. It has been given the power to “produce” money by simply using printing presses. There is very limited number of banks and primary brokers who have access to the FED issued “loans” at very attractive (low) interest rates. Although those rates are low (relative to the general market) the interest earned by the FED is very substantial since it is applied against huge amounts of money loaned.

Since the FED and its private owners did not invest any of their own money, but instead only the “printed” money and the huge interest earned is paid in real money, the actual earning of the FED owners is enormous and it is based on zero investment.

Is the above correct to any degree?

Thanks

Dan

Dan said...

LB

What happened with my question on the FED?

It showed up in the string and now is not there any more.

Any idea?

London Banker said...

@ Dan,

Your first comment was caught in the spam filter, where I retrieved it for publication.

The Fed isn't just one thing. The Federal Reserve Banks are owned by the banks of their districts but are subject to the Federal Reserve Act restrictions on their powers and authorities. The Board of Governors of the Federal Reserve is a federal agency whose employees are civil servants.

When the Fed buys Treasuries, it gets pad the interest, but it rebates 85 percent of the interest to the Treasury. This is why QE2 is so important for financing the huge federal deficit at an affordable rate just now.

Yes the banks that own the regional Federal Reserve Banks can profit from their profits, but that is not a primary motivation for policy in my view.

More important, policy and regulation are made by the Board, and the regional banks have to follow the Board's requirements.

Anonymous said...

Studying the US TIC data, I became curious about the unprecedented increase in Canadian holdings of US government debt. In discussion with the Canadian statistic agency, I determined that there was a net divestiture of US government bonds YTD through October. Further discussion reveals that the Canadian numbers exclude holdings by Canadian chartered banks for their own account and official reserves held by the Bank of Canada. It seems reasonable to conclude that these excluded entities purchased over $75B YTD through October. The last 12 months of net purchases, according to the TIC data, is over $88B or about 6.6% of Canada’s 2009 GDP.



The significant reported Treasury purchases by Canada and the UK warrant investigation. What may be occurring here is a sort of stealth quantitative easing. Reserve requirements for AAA sovereign debt is zero allowing an entity to effectively accumulate an unlimited supply of Treasuries. I suspect that some amount of Treasury purchases beyond QE are actually financed via bank debt creation or shadow QE if you will.

Anonymous said...

Continuing...

Shadow QE along with CB QE explains how the UK can sell one year Gilts under 1% with inflation running at over 3%. Interest on effectively zero principle is an infinite return.

Short of closing the output gap, hyperinflation is the ultimate result.

kliguy38 said...

your writing style is a breath of fresh air in a sewer of fiat corruption...Please continue with your posts for the sheeple...

Anonymous said...

london banker..

good to see your powerful but elegant prose again..

thanks from the west coast..

Anonymous said...

Okay L.B., thanks for your return. Can we look forward to additional writing, or is the wind out of your sails?

And please, can you weigh in on your expectations for the future of the US and European economies? I spent the better part of the last 3 years waiting for the apocolypse, but now the apocolypse seems quite sharply on sale. I see things heating up in many ways, but I realize that often not all is as it appears.

Will sovereign debts cause another crisis or just quiet, private pain in the form of reduced income for pensioners and public employees in Europe?

Will US QE2,3,4,5 etc. come back to haunt us, or will it be a big "no pasa nada"?

All your opinion, of course, but you are erudite and informed and your opinion means a lot. Thanks and please have a very happy new year, the holiday and for all of 2011.

RTS

Anonymous said...

Seems to me that in a ZIRP + TBTF + QE regime the 0% weighting imply central banks are simply cross-subsidizing each other.

Deflated said...

Strange that I haven't clicked this bookmark for over a year and was close to deleting it this evening but decided to give it one last click. Glad I did, welcome back.

I decided to take at look at the comments on 25 November 2008 02:53 and see how my list of predictions had turned out. Not all in the right order, and some of my causes and effects turned out to be very tenuous (to the point of irrelevance) - but here we are at stage No. 30 and the show goes on!

Deflated said...

@LB
I have been re-reading the notes I made while this blog was running in 2008, and I have a request - would you revisit this post:-Deflation has become inevitable
and perhaps take Liam Halligan's inflation expectations into consideration?

(aside: the word verification sitting below as I type is "mizeses" - reminds me of Ludwig von...)

Mark said...

I trust you will find the time to add more to your writings here: there is so much upon which comment could be made. Some things have turned out as expected, and others not. But there;s still a lot of turning out to do.

Anonymous said...

Basel III includes a Credit Risk Mitigation component, which requires banks to add a factor to credit risk capital calculations for credit risk migration.
Essentially, you model the effect of a change in credit spread on an instrument/issuer (e.g. Greek Eurobond) on your entire book, and convert that to a multiplier on the economic capital for that instrument.
It is an extremely complex process, designed to hide the fact that Basel II capital requirements are the source of the mess that Basel III is supposed to solve.

beauty said...

Glad to see you back, think this funny "10 Commandments For Managing Basel II" - written as a parody - exposes a lot of flaws in terms of gaming bank leverage, at the margins at least.