Wednesday, 13 July 2011

Basel Accords: "Tissue paper over a mountain range"

In 1987 I used the title of this post to describe the brand new Basel Capital Accords. I was a young and novice central banker, but as soon as I looked at the proposed accords, I knew they were sowing the seeds of a great misallocation of capital. The principal flaw was the uniform weighting of assets:
- zero weight for OECD government debt and all other government debt with less than one year maturity;
- 20 percent weight for debt of OECD banks;
- 50 percent weight for mortgage debt.

Young as I was, I had the confidence to express to my elders and betters that they were making a mistake treating a French bank - with unlimited state support - exactly the same as a Italian bank - where state support would be subject to greater political and currency risk. Given the massive differences in yield and liquidity, how could an Italian government bond be just as good as a US Treasury held as bank capital?

The enthusiasm of my colleagues did not convince me. I knew that by drawing these clumsy rules we were telling banks that they no longer had individual, direct responsibility for assessment of the creditworthiness of their assets or their bank counterparties. The banks could use the uniform weightings of Basel to justify bad judgement and lend to Italian banks just as if they were French. Worse, the zero weighting of all OECD government debt would make Italian bonds just as good as Gilts or Treasuries as capital assets, despite more volatile liquidity and the obvious credit risks. [Italian governments changed almost weekly back then.] If the bank regulators slapped a label of capital adequacy on a bank, they would keep on lending unto disaster.

"But no!", my colleagues declaimed, "We are making the world safe for capitalism. With level playing fields from here to West Germany, American and British banks can grow internationally in every market because competition will favour more efficient international banks." [At the time the Soviet Union was still a bar to capitalist extremism in Eastern Europe and we were all devoted to Chicago School free markets elsewhere.]

Basel Capital Accords did promote global competition, and so the concentration of global banking into a very few global banks by punishing smaller banks with higher capital requirements. And to that extent, the plan worked to favour Wall Street and the City. The plan also worked in favour of the Italians, who could issue copious government debt to capitalise their banks at the zero risk weighting and flog that debt to American, British and German banks who carried it at zero risk too.

But as the American, British and German banks were relieved of the onerous responsibility for due diligence, they took sillier and sillier risks. For example, they bought lots of Italian government bonds. They spread the emergent model of securitisation far past any productive reinvestment of capital to the point of wasting each nation's decades of accumulated wealth to finance excess consumption. They bought ratings from willing rating agencies to justify more and more leverage with less and less capital. They used derivatives to make their balance sheets and accounting impenetrable and misleading, and then got governments to adopt the same techniques in the public sector to support increasing government debt. And all the time the bias of Basel made them more and more powerful.

Basel II cemented big banks' control of both regulators and markets. They could use ratings to justify investments in structured products that seemed to have no economic rationale for either investors or intermediaries, but were magically profitable for everyone in theory. They could use internal models to book profits now and defer losses indefinitely, so ensuring wonderful bonus growth. Ah, glory days!

It is all starting to unravel now. Despite a commitment to Basel III - to be implemented far in the future - I doubt Basel II will last much longer. This week saw Portugese and Irish government bonds downrated to junk. Even the mighty US Treasury is on creditwatch for downrating given the rising risk of default.

Junk rating means risk. Recognition of an asset as capital implies that it can be priced in a liquid market when cash is required. When sovereign debt is junk rated and only good for collateral at the ECB or Fed, then it should not be eligible for bank capital. And so, zero weighting of these bonds as bank capital assets is no longer defensible. The banks holding Irish and Portugese debt as zero weighted for regulatory capital will have to supplement their capital at a time when bond markets are already dysfunctional and becoming downright illiquid for new issues. Huge maturity mismatch and refinancing overhangs were already threatening banks over the next few years, and now it will be much, much worse.

The ECB has ripped up its liquidity facilities rulebook this week to permit Portugese government debt to remain eligible as collateral despite the downgrades. That just tells the banks that there is no longer any rulebook that will not be ripped up as the occasion requires. And that inevitably includes Basel II and Basel III. The ECB has doubled down on moral hazard.

Watch the banks use the next crisis to ensure that no rules apply to them at all. Basel II will be suspended as regulators come under pressure to agree to continue to zero weight even junk bonds, despite high risks of sovereign defaults. You won't hear the Portugese, Irish, Italians or Spanish - or likely even the Germans - object to that when the time comes and the alternative is recognition of widespread capital deficits and bank failures.

But if the Basel II rulebook gets ripped up, that will also destroy the means by which the banks suborned regulators, central banks and governments to their service, chasing ever higher yields and ever bigger marketshare. I'm not sure what will come after that, but it probably won't have zero weight and certainly not zero risk.

Related posts:
More on the lunacy of the Basel Accords
Basel Faulty: Sovereign defaults and bank capital