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

19 comments:

Knute Rife said...

The banks are now Humpty Dumpty, "When I set a risk rating, it is just what I choose it to be, neither more nor less." How deep does that rabbit hole go? We are now living the nightmare Jefferson feared and that Hamilton believed would not happen: the actual control of the political and social institutions by the financial.

Anonymous said...

If you were a shooter, you'd have completely missed the target off of a benchrest at 50m.

It is precisely the missrating of your 'as good as' Gilts & Treasuries that has lead to the burden of bad debt that we all face today.

What bank do you work for?

Anonymous said...

I take my hat off to you London Banker. One of the few sane and truly knowledgeable voices.

Fabrice_BM said...

Excellent analysis.
You belong to the few that truly the misconceptions of the global financial scheme.
Thanks for explaining this so clearly.

Richard said...

Excellent post, although I am far more optimistic about the resolution of our current financial predicament than you.

For example, I do not think that the US can adopt Basel II or III because the Dodd-Frank Act requires regulators to end their reliance on credit ratings. So much for risk-weightings.

So another solution will have to be found.

This solution may have come from the Institute for International Finance, a global lobbying organization representing the largest financial institutions, which is calling for effective regulation.

They defined effective regulation as combining the banks providing all the useful, relevant data with supervision that knows how to use this data to promote financial stability.

There exists a group of market participants that could provide this supervision. This group is the banks themselves along with credit and equity market analysts.

Anyone with an exposure to the banks, and this includes government regulators through deposit guarantees, has an incentive to analyze this data (or talk to other market participants who have the expertise to analyze this data) and adjust the price and amount of their exposure to reflect each bank's risk.

In short, the Institute for International Finance is calling for the restoration of market discipline.

My speculation on why they are pushing for a restoration of market discipline is bank management realizes that governments are in no condition to bailout the banks again and this is the only way they can protect themselves from what Jamie Dimon referred to as his "dumbest" competitor.

But, how can we get from where we are today with plenty of insolvent banks, to a financial system where there is market discipline?

By adopting current asset and liability-level disclosure.

As the IIF made clear, well run banks have nothing to hide and they will quickly make their current asset and liability level data available.

For banks that would rather not disclose this information because they are insolvent, national supervisors should stop praying for a miracle. Instead, they should take over the banks and resolve them.

scandia said...

@Anonymous re the perceived " misrating " I think you should read the post again. It was London Banker's " enthusiastic colleagues" who rated all equal to Gilts and Treasuries..

john said...

Looks like a big shakedown is imminent with the outsiders being given enough rope to hang themselves. fffing lunatics

Steve R. said...

Thank you for your help in illuminating our problems so that the can be exposed and understood and rectified ..

AllanW said...

Thanks for the clarity and sanity.

RebelEconomist said...

Nice turn of phrase LB! When I was introduced to capital adequacy as a novice central banker a year or two after you (not as a financial supervisor, so we may not know each other), my poorly informed impression was that the simplifications you describe were fair enough, because the self-preservation instincts of principal investors and the discretion allowed to financial supervisors would fine-tune risk management to prevent most disasters. Looking back with more experience, I underestimated the cynicism of both buy-side and sell-side agents, and the demanding but lazy nature of the principals. I doubt whether any capital adequacy or supervisory regime will suffice. What is needed is realistic accounting and rigorous bank resolution so that, in future, the principals pay attention (not to mention that using more of the principals' wealth in the clean-up would reduce the burden on the public).

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Carter the Examiner said...

The fundamental problem that led to Basel II was that banks internally themselves did not properly price\reserve for the risk. Some markets, such as Italy, before Basel II, were characterized by binary decisionmaking (good or bad credit).

Risk based capital is not inherently flawed, in fact it is what each and every banker\investor ought to do of their own accord.

The problem is building the regulatory regime off of this. If banks do have the aforementioned incentive, then the role of the regulatory capital regime should be to control for errors in the classification within the regime - mostly credits assigned a risk charge that is too low (and hence allow the bank to operate at too high leverage).

And the way to do that is with a simple leverage ratio.

PeterJB said...

I am now of the firm intellectual belief, after years of reading Economic works of Economists and actively participating in Economists' Blogs, searching for the fundamentals behind today's socio-economic driver, that is the credit distribution system (CDS), that the state of ‘Economics’ as it is practised, is nothing but a totally fraudulent persuasion,and has been been for at least 300 years, or more, with its fundamentals rooted in the US demand for exogenous spoils through looting, by the continuity of war activities and diplomatic imposed national intimidation – fully, a priori, and necessarily supported by the largest and most sophisticated military force – that exists, which just cannot, incompetently and managerially, win a war –because, that is the intention and purpose of its own National ‘economic practise’.

Where, the field of Economics has be captured, consensually captured by self-surrender and further, as such, devoted to being the apologists for the total corruption and deceptions of "Economic Theory (ies)" in practice.

All this, while the so called US Gold Standard was nought but a Central Bank fraud — as is now the whole Global Banking system.

The World has been conned and fooled! It is all illusion and created through time and education; delusion! Bernasean Propaganda or Public Relations.

All – “Economic Theory” and “Economics” is “store high in transit” – it is mere sophist opinion; nothing more and nothing less; but preferential opinion and nothing more than convenient opine and ignorance that allows it to be propaganda-ized through the whole public socio-economic spectrum of human action.

That is to say, the education demand (for Economic creditability) which, upon realization, in order to survive, must be immediately forgotten or at least discarded.

Economics is at best, a Profession of Prostitutes, without Ethics and or Morality!

The ruling socio-economic force is Banking — which controls by the establishment of Central Banks which projects its controls through franchised political power and centralizes returns via a mandatory and major “interest” on all productivity, ad infinitum, a priori. The Banking system is a parasite which is predatorial, a priori! Banking is the Giant Squid and feral fungi Candida; It is also a system that corrupted the political and bureaucratic and maintains control through its systemic reason of being aka nature and kind.

There is no “Economic Theory” per se, only control through stealth and deception taxation by inflation by its Central Banks mechanisms.

There is a need for Human Consciousness at the global breadth to evolve to the point of exposing this Economic Fraud of organized crime by political being and Policy on the human economy!

And it is... thankfully.

Sadly, you will not believe these words. But, if you did, humanity would be far less traumatized by the coming future consequences!

scandia said...

@ London Banker, Wish you would comment on current events as in where will the money come from to continue to protect the bondholdrs, the very system itself?

Hayes said...

Discovered a New>? version of RGEmonitor run by Roubini with open access. Lots of guest posts etc..

It is called EconoMonitor - A Roubini Global Economics Project

http://www.economonitor.com/nouriel/

PeterJB said...

Is the Bank of England causing the riots through failed economic policy?

http://www.guardian.co.uk/business/2011/aug/14/quantitative-easing-riots?CMP=twt_gu

As the Bank of England considers unleashing a fresh round of QE, Dhaval Joshi, of BCA Research, argues the approach of creating electronic money pushes up share prices and profits without feeding through to wages.

"The evidence suggests that QE cash ends up overwhelmingly in profits, thereby exacerbating already extreme income inequality and the consequent social tensions that arise from it," Joshi says in a new report.

Isn't it about time that Economics be subjected to the scrutiny of scientific processes? Today's economics is merely "opinion" but politically biased "opinion" coloured by the expediencies of self-agenda.

“In order to help each other to cover up bad deeds, one forms a party.” Confucius

scandia said...

The proposal of eurobonds sounds like another attempt to grade all countries in the eurozone equally as you pointed out in a previous posting.Is the eurobond another financial " product " to protect the bondholders? There doesn't appear to be enough protection money left?

Anonymous said...

LB,

Time for a new update. Thank you.

Anonymous said...

Managing risk - good.
Killing any assessment of risk - Ouch!