Monday, 13 December 2010

Basel Faulty: Sovereign Defaults and Bank Capital*

A foolish consistency is the hobgoblin of little minds, adored by little statesmen and philosophers and divines. - Ralph Waldo Emerson
When historians of the future look objectively at the era preceeding this long financial crisis, they might well conclude that failure of the globalised capital system is traceable to the Basel Accords.** The unreasonable assumptions and myriad distortions introduced in this one-size-fits-all paradigm of bank capital adequacy fatally undermined the practice of independent judgement in assessing credit risk and prudential supervision of banks.

Bankers of the past had to assess the creditworthiness of a debtor or counterparty based on balance sheet, revenue potential and management reputation for competence. They husbanded their scarce capital, aware that each dollar lent remained at risk until repaid, with cash reserves proportional to the bank's assets usually 8 to 10 percent.

A primary fallacy of the Basel Accord is that OECD government debt is risk free and requires no bank reserves. Better yet, the banks can count the government debt they hold as Tier 1 capital, reserving against other debt assets. The Basel Accords assume all OECD government debt is a cash proxy, being liquid in all market conditions.

Walter Wriston's 1970s dictum that "sovereigns can't default" was disproved in the Third World Debt Crisis of the 1980s, but somehow the BIS Committee on Bank Supervision still embraced it when applied to OECD state debts.

Roughly, the risk weights of the main asset classes under Basel I were:
- zero for Zone A (EEA and OECD) government debt of all maturities and Zone B (non-OECD) government debt of less than one year;
- 20 percent for Zone A inter-bank obligations and public sector entity debt (e.g. Fannie Mae, Freddie Mac, et al.);
- 50 percent for fully secured mortgage debt;
- 100 percent for all corporate debt.

The post-Basel bank supervisors applied their prudential supervision models unthinkingly, to rubberstamp the bankers' leveraging of their balance sheets toward ever greater excess. No one bothered to ask whether Basel Accord assumptions made sense. They were the harmonised norm for prudential supervision and too deeply embedded in the fabric of international finance to adjust, except to allow more and greater leverage in Basel II through liberal recognition of derivatives. Basel II allowed the banks to offset even more risk exposure with even less capital through collateral, securitisation, credit default swaps, and recognition of the validity of internal asset valuation models.

Global harmonisation of prudential supervision around the Basel Accord meant that the hobgoblin of excess leverage became systemically entrenched in all markets, in all nations. The foolish consistency of harmonised capital adequacy was adored by little minds of global bankers and central bankers worldwide.

The zero weight for OECD government debt must have appeared a harmless subsidy to OECD governments in 1988, promoting liquid government debt markets and enhancing the competitive positioning of OECD-based global banks who stood to gain most from the harmonisation of global bank regulation and capital rules.

Leveraging their balance sheets to work every dollar of capital harder became the obsessive preoccupation of two generations of bank executives once the Basel Accords were adopted. Risk management departments were less about controlling exposure to adverse credit events than about identifying deal structures which would minimise the amount of regulatory capital allocated to any exposure.

Fannie Mae, Freddie Mac, and their ilk were an early mechanism to reduce the reserves required from 50 percent on an individual mortgage to twenty percent or even zero, allowing the banks to write more and more mortgages with less and less capital. When these entities proved inadequate in the go-go 1990s, asset back securities allowed banks to get sub-prime mortgages - and thereby the capital requirement - off their books entirely, passing the risks to yield-hungry investors. With Basel II they could reduce capital even further by writing each other a daisy chain of credit default swaps for all categories of exposure. Who could have known that it would end badly?

OECD government debt is zero risk weighted and accounts for a disproportionate bulk of Tier 1 capital of major banks. A default by any EEA or OECD government will force banks and central banks to recognise that government debt has inherent risk like all other debt. This would force recognition of a positive risk weighting, and bring into question the assumption that government debt can be counted as a cash-proxy in Tier 1 reserves. The illiquidity of impaired or defaulted government debt would undermine its role as a Tier 1 reserve asset in bank capital models.

At this writing the OECD governments at risk of default are Greece, Portugal, Spain and Ireland, with other states queuing up in the wings. Already the ECB is the only buyer in the market for much of the impaired government debt.

If any OECD state were to default there would be very serious implications:
- The Basel Accord zero risk weight of government debt would be proved fanciful;
- The assumption of government debt as a liquid asset suitable for bank Tier 1 reserves to meet unanticipated and sudden cash demands will become unsustainable;
- Banks would be forced to recapitalise at much higher levels, forcing even sharper deleveraging and contraction of lending;
- Governments would lose the captive, uncritical investor base they have relied on to finance excess public expenditure for the past 30 years;
- Central banks could be forced to suddenly monetise even more government debt if required to meet the cash demands of a run on their undercapitalised banks.

Looked at this way, you should be able to understand why the ECB keeps repeating that there can be no Eurozone sovereign default, and why the UK and US are staunchly behind them in preserving the illusion of state solvency for all Eurozone states.

It will likely prove impossible to reform the bankers and central bankers dependent on the Basel Accords for their business models and careers. Harmonisation of global standards was supposed to make the world safer. A foolish consistency on bad policy and bad practice led instead to a world on the edge of financial implosion.

This hobgoblin haunts us all.
______________________________

* Hat tip to Tracy Alloway at FTAlphaville for suggesting a revision to the title for this post.
** Several commenters questioned my spelling of Basle Accords in the original post. I prefer the British/French Basle which was standard in my youth on Basle Accord documents, to the German/American Basel more common and current today. Nonetheless, I yield to the customs and usage current today in changing the spelling to Basel.

34 comments:

Adam said...

Good to have you back.

Dan said...

What is the conclusion...if any is posible at this time? Where do we go from here?

Detlef Guertler said...

So Basle turns out to be something like Bretton Woods?
Let's see: Bretton Woods worked well for about two decades, from 1944 to the mid 60's, went through one decade of worsening crises and was abandoned in 1973, after 29 years.
Basle I was established in 1988 and worked well for about two decades. Its crises have begun in 2007, so there would be some years left before it will be abandoned.

Anonymous said...

I second Adam - good to see you back!

What changed your mind about writing - did you change jobs?

Keep up the good work!

London Banker said...

Thanks to all who have welcomed me back here.

@Dan, Where we go from here is differentiation as more central banks veer away from Basle Accord as the only way to regulate bank capital. PBOC policies in China apply stricter capital controls and administrative regulations to limit risk exposure and shape bank policies. Even in the EU, there are some discussions of segmenting the banking sector into narrow and broad banks, with stricter reserving policies for narrow banks holding insured deposits.

@Detlef, Interesting parallel on Bretton Woods. BWI fell apart when creditor states issued a margin call on US gold reserves. Basle II will fall apart when creditors refuse to further fund sovereign deficits and central bank monetisation remains the only game in town. The idea that illiquid, unpriceable sovereign debt can be Tier 1 capital for a huge weight of assets will then be impossible to justify.

Anonymous said...

Just two weeks ago or so, I saw you comment on an article on ZeroHedge. I did not recognize your "London Banker" name, but I was impressed by the reaction of others to your post ("is this really London Banker?", "I remember your posts on Roubini's forum", etc.). I became curious and Googled you and found this blog and bookmarked it.

I looked again 2 days or so later and you make your first post in a few years.

Excellent article today. People need to hear more from you, espcially concerning your thoughts about the future of the economy, banks, etc.. I for one have gone from being completely normal until 2008, to a paranoid case believing all manner of consiracy theory and awaiting the imminent apocolypse of the Western economies, to now not knowing what to believe, when even my personal day to day observations leave me clueless as to what's happening.

Your perspective is most welcome in these times and I am very happy to have discovered you at exactly the same time you are re-emerging. Please keep it up.

RTS

Anonymous said...

Hello London Banker and All
@Dan, Prepare for the worst and hope for the best. Train your mind to appreciate the positive in any situation for the outcome is simply unknown following the said "implosion." God and probably Goldman know how and when…

I have been searching for work for the past year or so and have had to rely on faith, exercise and positive thinking among other things to keep me going. I have not followed the day to day as I know enough and did not want the negative economic reality to skew my pursuits for employment. As before, higher equity prices serving as Xanax or Prozac or opiate to the unsuspecting masses do not alter my view of reality.
Amazingly, US dollar minded folks still play along with the oh so familiar shell game involving a lower us dollar and higher nominal asset prices. Where was the us dollar index the first time the s & p 500 index hit 1,500, where was it the last time and where will it be the next time if ever? Will all play along and dance and sing to s & p 500 5,000 (Bovespa-like) while the dollar plummets? Are all assets moving together again? I have been listening to Christmas tunes lately. I think I will go back to that and away from this…
Happy Holidays!
C a p o n e

London Banker said...

@RTS, I'm glad you found your way here, and welcome.

@Capone, Glad you dropped in! Sorry to hear you're looking for work in these hard times, but sounds like you've formed a good strategy for getting through it. The exercise and positive thinking are critical disciplines, and I've made it through hard times myself using the same method. As I used to say years ago, the best investments you can make for these uncertain times are in your marriage, family, friends and local community.

I'll sing "Good King Wenceslas" with you in mind this season, and send happy thoughts your way.

Anonymous said...

London Banker, I'm delighted to see you back up and at it.

If I understand your essay, you're writing that that there's nothing inherently sacred about sovereign debt. Thus, sooner than later, an informed buyer will purchase the debt of a nation that is sound --i.e., an issuer whose spending is within the bounds of productive capacity.

Would you agree with the points made elsewhere?

1) the real issue for sovereign issuers is the threat not of solvency, but default via hyperinflation and spending in excess of productive capacity - a point that Roche and others make. http://pragcap.com/bernanke-makes-it-a-trifecta-of-ignorance.

2) Many of the best US minds are fundamentally confused about this. http://pragcap.com/thoughts-an-open-letter-ben-bernanke and http://pragcap.com/america-problem

While part of me has hoped otherwise, there seems to be no avoiding the deleveraging process and the need to ramp up our personal and regional/national productivity (in a sustainable manner).

Capone, I remember both you and LB from your fine comments at RGE. Sorry to hear about your difficult employment search. Hang in there. May things turn up for you soon.

James

Modern Money Mechanics said...

Hi LB,

Always enjoyed your posts over at RGE. Glad to see you are back in the blogging saddle.

Love to here your analysis of the JP Morgan silver squeeze promoted by Max Keisor (Crash JP Morgan, Buy Silver). Keisor says Morgan has $3.5 trillion in naked shorts.

Harvey Organ (http://harveyorgan.blogspot.com/) has never seen such bullion movement gymnastics in his 35 years of watching COMEX. JPM appears to be offering huge cash settlements instead of delivery. Nevertheless, longs are holding for Dec delivery of 8.815 million Ozs.

Do you think JPM is vulnerable? Why?

London Banker said...

I've known Capone so long I remember him as JMa! Good times down in the comment thread on Roubini's blog back then before the paywall broke up the posse.

I cross-posted to Roubini.com yesterday, as I'm still grateful to the Professor for lifting me out of the comments and giving me blogspace, but there are no comments over there.

If I don't get a dialogue going in the comments, I might as well be writing to myself.

London Banker said...

@MMM
There is something very wrong with market supervision at the FSA and CFTC when single traders control more than 40 percent of silver on the Comex, and between 50 and 80 percent of copper and nickel on the LME.

I think market supervisors have forgotten that markets do not exist as playgrounds for speculators backed by central bank credit. They exist - and are regulated in their functions - because they are critical infrastructure to the efficient production, allocation and consumption of commodities critical to economic health. Their primary function is accurate and rational price discovery.

Production is the bedrock of economic prosperity. Distortion and manipulation in the pricing of basic inputs make it harder for businesses in the real economy to operate profitably, and reduce the incentives to invest in future production. That damages economic growth.

The banks may be making huge profits on their manipulations, but we will all pay the price in loss of jobs and loss of economic growth for the future.

And I do know that drawing the lines between market making, speculation and manipulation is not easy. But that is what we pay market supervisors to do. If they don't do their job, real businesses, real workers and the real tax base of the economy really suffers.

Anonymous said...

James, thanks for support and the "fine comments" note!
LB, it was a nice surprise to receive your mail announcing your post. I have honestly been nearly 100% away from following the day to day for some time now as I have had to accept that I am neither God nor Goldman. Thanks for the post and thanks for the Good King Wenceslas thoughts - I just had a listen. Yes, there were many lively threads back in the day at Roubini's blog while the mess unraveled.
I wish there would have been some type of get together of the old fashioned type in person for the group over at RGE to see who everyone was. I had brief contact with Rich Hartman aka Miss America while I was out in NYC once, but we never connected...
I could not agree more with "As I used to say years ago, the best investments you can make for these uncertain times are in your marriage, family, friends and local community." add to this planting a garden :)
JMa

London Banker said...

@JMa, You are quite right about the garden! There is nothing more satisfying to body and spirit than sitting down to a meal where some part of it was grown through your own efforts. I have even thought lately about chickens . . .

CrackWhoreGold said...

Great to see you back LB, I hope you will post more often. I will certainly drop in and add the odd comment.

Detlef made an interesting comparison of Basle and Bretton Woods.

In your Spain Aa1 rating comment on ZH you wrote:

"The default setting of Europe in a crisis is to collaborate and meet challenges collectively through shared sacrifice. The default setting of the USA in a crisis is to attack and unilaterally rape and pillage enemies and allies alike. The crisis we are witnessing today shows the dynamics in combination. The USA is deliberately undermining EU institutions and confidence, and the EU is deliberately strengthening its institutions and promoting shared austerity."

As a Swiss citizen who is both glad and proud that Switzerland avoided getting sucked into the EU vortex, this comment irks me.

I would contend that the EMU is more like Basle than Bretton Woods is. EMU was more than anything else an attempt to consolidate control and steal the sovereignty of the EU states, and the currency risk of all the national currencies would have made the zero weighting of sovereign debt in Basle impossible. Your statement below applies to the EMU as well, just replace Basle Accord with EMU:

"No one bothered to ask whether Basle Accord assumptions made sense. They were the harmonised norm for prudential supervision and too deeply embedded in the fabric of international finance to adjust, except to allow more and greater leverage [loss of sovereignty] in Basle II."

I see that in your blog list that you link to Ambrose Evans Prichard, a well known EU sceptic. Your post about the EU on ZH leaves me confused...

London Banker said...

@CWG, The zero weighting of sovereign debt goes back to the earliest Basle Accord in 1988. This was the factor that allowed perennial deficit states like the USA, Italy and Spain to run up bigger and bigger deficits while Greenspan kept monetary policy loose. The two worked together, with government bonds sitting zero weighted on balance sheets as Tier 1 capital while leverage grew from the conservative norm of 8x or 10x to 20x or 40x deposits.

I am not a eurosceptic, despite recognising that Thatcher made excellent points in her cautions about the structural weakness of a single european currency. I'm glad to have an EU passport, although I would be more comfortable with more accountability of EU institutions. I'm against centralising any more budgets without transparency and accountability. The link to AEP is because we agree more often than we disagree, although I am far less eurosceptic than he.

Anonymous said...

So why is it that Ireland did not cut a better deal, given that everyone is in the same boat and they have their finger on the MAD trigger...

Mixing metaphors and cocktails at this late hour.

scandia said...

@Anon ..." so why didn't Ireland cut a better deal?' Ha! I've been wondering the same thing and concluding that the gov't is on the take.

di said...

LB, vraiement enchante Monsieur de vous conaitre. I worked teaching VAR concepts to burned and chastened Asian financials after the last crisis in 1997. How ironic that the doctors have now become the patients. Your Tier 1 comments are spot on x10. What I believe we must add to this discussion is the role off balance sheet derivatives will play in this economic boiling soup. They are considered 'ok' on a net basis but their actual size and propensity to correlate to 1 in a crisis will have a further destabilizing effect, thus increasing the need for more reserves. And if Tier 1 is suspect? We have the makings of a classic vicious cycle.

peter said...

Could I recommend chickens for the back yard?
Against my wishes my wife obtained 4 chooks and they have been hard at the job of making eggs for 12 months now. The combination of the sounds of happy clucking and good eggs in the fridge has won me over.
The cost of these eggs was high at first thanks to building a fox proof enclosure.
You do some things for intangible reasons eg chooks, kitchen gardens etc. but the pay off comes in ways that satisfy.

I look forward to reading your writing on the present situation and our uncertain future.

JoeBlo said...

LB- Glad for your return. Look forward to your insight, but it may be just in time for a bumpy ride.

Anonymous said...

LB and all, apologize for slight off topic... may i ask a question regarding potential US state municipal defaults? many US states are running huge deficits, any guesstimates or thoughts on timeline of when this may unravel? likelihood of it unraveling? actions that will be taken to cover deficits of state budgets - federal versus state taxpayer bailouts?

c a p o n e

Atticus said...

So that leaves the question: if you don't like sovereign debt for bank reserves, what DO you like?

Also, you might see these articles from a potentially kindred spirit on the other side of the pond.

http://strikelawyer.wordpress.com/2010/12/08/money/

http://strikelawyer.wordpress.com/2010/12/11/money-ii/

http://strikelawyer.wordpress.com/2010/12/11/money-iii/

London Banker said...

@ Di, JoeBlo - Welcome
@ Peter, The idea of fresh eggs from the backyard is very attractive.
@ Atticus, I favour forcing banks to hold cash reserves, as intended by Bagehot and as required by central banks during long periods of stable prosperity. The distortions introduced by the Basel Accords gave sovereign debt the same value as cash as a reserve asset, creating a subsidy to soverieng borrowers and leaving the banks badly exposed to a liquidity or confidence crisis by inadequate reserving.

With the sovereign debt of Ireland, Spain, Portugal and Greece all but bidless except for the ECB, and Italy and Belgium a problem too, that banks continue to carry these debts as Tier 1 reserves is a nonsense. A demand for liquidity leaves the bank affected putting the bonds to the ECB to raise cash.

Cash reserves (without the distortion of Basle credit weightings preferring sovereign debt, agency debt and mortgages) would force banks to think more carefully about where they lend their money and pay more attention to structuring their liquidity position to retain investor and depositor confidence.

2cents said...

LB it’s a pleasure to have you back in pocket! Gone so long but really just a blip in the continuum.

I just found your new posts and really liked this one about sovereign default. I’m not sure how your site is going to flow, but I will make this comment here for continuity sake even though I see you have a newer post.

I would like for you to consider an alternate view regarding one of your replies here in the comment section: “I think market supervisors have forgotten that markets do not exist as playgrounds for speculators backed by central bank credit. They exist - and are regulated in their functions - because they are critical infrastructure to the efficient production, allocation and consumption of commodities critical to economic health. Their primary function is accurate and rational price discovery.

Production is the bedrock of economic prosperity. Distortion and manipulation in the pricing of basic inputs make it harder for businesses in the real economy to operate profitably, and reduce the incentives to invest in future production. That damages economic growth.

The banks may be making huge profits on their manipulations, but we will all pay the price in loss of jobs and loss of economic growth for the future”



While I agree with this view, I don’t for one minute think that market supervisors have forgotten as you say. Rather, I think it’s a measure of how deep down the $&^# hole we are. They problem is they know exactly what the markets are supposed to do and they should operate. But they know that if they enforced that functionality everything would collapse in moments. They do it all for show right now. Maybe with just a little more time the magic will go on.

Would you want to be the one to tell the band to quit playing and tell everyone the party is over?

I’m afraid at some level everyone is just plain scared to act in any direction because the house of cards is looking pretty precarious.

2cents

Anonymous said...

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Anonymous said...
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Anonymous said...

LB

It's refreshing to see you back in action. I remember the good old days on Nouriel Roubini's blog when you used to rail on about the corrupt leadership in Wall St and Washington (" there are no adults left in charge"). Sadly, the USA is now sinking into its own debt-trap ... and we can see how right you actually were. Someone above complained against the lack of proper regulatory standards at the CFTC - that's just one very painful example of what I'm talking about.

The global financial system has fought strongly against the principle of deleveraging. It's maddening to watch because it makes no sense. Clearly we are at the stage now where small nations with excessive debt levels should actually default and undergo re-structuring - but the ECB is coming to the rescue. No doubt the Fed will also act to support bankrupt US states such as California.

Ultimately this will transfer the financial risks to larger sovereign states. Countries like Italy could wind up paying substantially higher interest payments on their high levels of debt. But I remain concerned about the unique set of difficulties facing Japan ... it seems hard to see how they can maintain economic competitiveness when their currency is appreciating so rapidly. I find it difficult to see how Japan can avoid a significant rise in their bond yields, and that would surely signal a deepening plunge not only in the Japanese economy, but in the economies of the major western powers (USA & Europe) as well.

Anyway - good to see you back!

PeteCA

London Banker said...

@ PeteCA
It's good to see so many familiar names on the comments here. I can't guarantee to provide the quality forum we all enjoyed back in the day on the Professor's blog, but I'll try.

London Banker said...

@ 2 cents
To some extent I agree that "extend and pretend" is a default for the regulators as they appreciate how precarious the (in)stability of the recovery is. At the same time, all the major economies bailing out their banks will be shedding jobs and growth to fund the interest payments on the massive socialised debt incurred in the bailouts. That is not good. We can keep bleeding jobs, tax revenues, capital investment in future technologies, and a lot else in favour of big banks siphoning off of cash for bonuses, or we can put the banks back in a box of sensible scale, capital and regulation.

London Banker said...

@ 2 cents,
For some reason, your post went to the spam file. I've ressurected it from there. I hope it doesn't happen again. I'll keep an eye on the spam file.

Anonymous said...

Here's an interesting article on the avalanche of defaults in municipal debt that is heading towards America in 2011. I found this article linked on www.financialsense.com

http://www.guardian.co.uk/business/2010/dec/20/debt-crisis-threatens-us-cities

London Banker - I'm sure your posts will be excellent. But I don't think you should feel under any pressure. I believe the recipe for success is simple - just to let your blog operate like a London pub. If you let people drop by and offer a few thoughts, the results can be very rewarding! And I like the fact that your current blog system allows anonymous posting by guests - it's simple and convenient (well worth keeping).

PeteCA

Anonymous said...

With prices for copper now hitting record highs ... the following article is fairly unbelievable.

http://www.marketwatch.com/story/single-trader-holds-90-of-lme-copper-wsj-2010-12-21

If this sign doesn't point to the ultimate volatility of the markets today ... I don't know what does.

PeteCA

Anonymous said...

Merry Christmas to everyone here ... both LB and the guests!!! It's good to see a few old names popping up on the blog.

best wishes,
PeteCA, Dec 24, 2010