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Why Basel III is No Magic Bullet

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There’s been an interesting dialogue between Streetwise Professor and Deus ex Macchiato on the matter of the practical impact of the pending Basel III rules, which will rejigger, in a pretty significant way, bank capital requirements (see here and here for details). The reason Basel III matters is that the Treasury has been touting it as the remedy for all the things that didn’t get done in the financial reform hoopla: if the banks are forced to have “enough” capital (query what “enough”) is, and better liquidity buffers, the likelihood of a financial crisis will be lower.

As an motherhood and apple pie statement, it’s hard to argue with that sort of thing, but making it operational is quite another matter. And here’s where the chat between Streetwise and Deus comes in. Per Streetwise Professor:

Risk-based capital requirements are like a regime of price controls, in this instance, risk price controls. If some risks are mispriced, and particular, priced too low, all affected institutions face the same incentives to take on those particular risks. The more institutions that fall under the capital regime, the more institutions that will take on these underpriced risks. That’s why I am very leery of global capital regimes, a la Basel. If they screw up the prices–and screw them up they will, with metaphysical certainty–the effect of the perverse incentives will be global…

This is a story about relative prices. In a risk based capital regime, some risks are mispriced relative to others. Banks load up on those mispriced risks. Since all face the same distorted pricing signal, they tend to trade the same way. They held more capital than they were required to, but that provided a false sense of security because the required levels of capital did not accurately reflect the risks.

There is, in fact, dysfunction in the financial system. That dysfunction, in the first instance, is the result of the deadly combination of implicit and explicit guarantees that stoke moral hazard, and woefully inadequate and scarily expansive capital requirements that are intended to make it difficult for banks to exploit that moral hazard, but fail to do so.

Let’s examine this a bit further. It’s important to recognize that the mispricing of risk under Basel II was a significant contributor to the global financial crisis. Eurobanks, which were subject to Basel II rules as of 2006, entered the crisis with lower capital levels than their US counterparts. Moreover, many engaged in a particular form of capital arbitrage that played a direct role in stoking the credit bubble, which was holding the AAA rated tranches of CDOs and insuring them (usually in part) to further reduce the amount of capital they had to hold. So the concern is valid.

Even with the likely (in Streetwise’s view, inevitable) mispricing of risk, the impact might not be as significant as he contends if the capital levels for the underpriced risk was still high enough. In other words, I’m not certain I buy the strong form of the “crowded trades” argument, a risk based capital regimes is inherently flawed. And Streetwise effectively concedes that point:

The capital required against certain instruments (government debt being another example) was too small relative to the true risks of those instruments. So too many banks loaded up on them.

But from a practical standpoint, his concerns are valid. The unrecognized crowded trade problem only make matters worse. Even if the authorities were to come up with a sound program, the crowding in the strategies that were cheap on a relative basis would make them riskier, and hence the render the required capital levels insufficient.

Let’s face it, the notion that we are going to have adequate private sector equity in the banking system anytime soon, if ever, is a fantasy. The way that Fannie and Freddie have stepped in to become become virtually the only mortgage issuer/securitizer, with the obvious aim of propping up the housing market and bank balance sheets, is a highly visible example of the extent of back door support to undercapitalized banks. Team Obama is of course trying to divert public attention from the continuing high level of support and regulatory forbearance via its continued iMission Accomplished “Paid back the TARP” three card monte.

Richard Smith did a bit of quick and dirty math to determine what it would take to adequately capitalize the shadow banking system:

Let’s just ignore the liquidity issue for the moment, and ignore the variety of business models of the various kinds of shadow bank, and require the shadow banks to put up a not very demanding 5% capital cushion and regulate to that, somehow. Assume, for simplicity, that we want to keep all that lovely shadow banking activity going and that shadow banks’ assets are identical in size to their liabilities; that 5% capital cushion would then be 5% of $8-16Trn. That’s between $400Bn and $800Bn of capital to raise.

Or, perhaps more likely, our shadow banks take 50% losses on 15% of their loans that they never never want to do again (the CDO bonanza, etc), and then need 5% equity on the rest. That way our shadow banks would need $925-$1,850 billion in equity. Which is impressive, but fair enough: the traditional banking system has about $1.3Trn of equity, and we know the shadow banking system is the same size, or somewhat bigger, and more prone to runs. Why, pray, should it not at least be capitalized to the same level, either by new capital, or by shrinkage?

Yves here. It is politically unacceptable to make banks raise that much capital. Not only would the firms howl blood murder, but policymakers are unwilling to take the economic hit of a quick or even attenuated return to sounder practices. So we have state subsidies of various sorts like ZIRP standing in.

That further means we have a continuing moral hazard problem. Basel III can’t solve the problem because despite the officialdom’s fantasies to the contrary, they simply won’t get enough equity into the system. That might not be as terrible as it sound if the authorities were willing to admit that and were using other approaches to monitor and reduce risk, in particular, much more aggressive regulation, and far more intervention on pay practices.

In the stone ages of investment banking, when firms were partnerships, it would have been unheard of to take on a lot of moderately long-dated, risky, illiquid, bespoke, hard to value assets and fund them in short term where they’d be exposed to rollover risks. Similarly, in those days, the major players all held a lot more in capital than was required by regulators (reg cap was regarded as overly permissive but constraining in certain circumstances, so it still needed to be managed). Investment banks were cautious not only because the partners had unlimited liability (they could lose everything) but also because they most if not all of their wealth tied up in the firm and could access it only gradually after departing, as younger partners bought them out over time. That forced them to maintain modest lifestyles relative to their net worth and to be concerned about the long term viability of the franchise.

We have a massive agency problem in the financial services industry. The crisis was a textbook case of looting. The major firms are now more powerful by virtue of being bigger and fewer, and official denials to the contrary, are in a better position to loot than before. The belief that higher capital requirements can be the mainstay of solving this problem is wishful thinking.

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  1. psychohistorian

    I think another consequence of Basel III capital requirements will be to further reduce the number of players, mostly at the low end.

    Who needs to enhance competition anyway? When you are mainlining money to the sociopathic rich, fiduciary responsibility to the public is so last century.

    NOTE: OT Comment
    Yves, I read the libertarian posting and thread with much interest and want to thank you for sparking such interaction which was for the most part well behaved. I encourage you to continue to challenge your readership to discuss other socio-economic tenets like inheritance (my favorite.

  2. charles

    Most analysts in Europe hint that the process would be less
    ‘painful’for the American banks than for their European
    counterparts. As for the B.I.S lingo, the risk-based
    capital requirements seem to focus on ‘hybrid capital’,
    much resorted to by the German banking system, and within the
    Basel III framework, specifically addressing the ‘cocos’ and the ‘triggers’ activating them..
    A brief ‘translation’:

  3. Siggy

    It is indeed the negative feedback loop of failed agency ethics and excessive leverage that lie at the core of the problem. Basel III will merely put a bandaid on what is an open sore exuding all manner of putrid discharge in the form of the latest item in the financial engineering production line.

    A really fundamental question is: Just why is that there are so many entities chasing yield?

    Going back to the partnership model may be one path to a cure, but unless and until the core cancer is eradicated we’ll simply be lopping off gangerous appendages until the only thing left is the head of a very poisonous hydra.

  4. Ed Beaugard

    Just out of cuiousity, what is the notional value of all the exotic derivatives out there? I’ve heard numbers like $600 trillion, could that be right?

      1. Ed Beaugard

        Quadrillion, that would be 400,000,000,000,000?
        Why doesn’t anyone know this for sure?

        1. Nathanael

          Nobody knows for sure because most of the derivatives were completely unregulated, thanks to stuff like Republican Phil Gramm’s so-called ‘Commodity Futures Modernization Act’, so banks could just make up as many as they liked *without keeping track of the total*.

  5. Tom Hickey

    As Bill Black, Frank Partnoy, Janet Tavakoli, Elliot Spitzer, Simon Johnson and others, including Yves, have pointed out, the problem is what Black calls “control fraud..” This is a forensic issue rather than an economic one and it should be dealt with for what it is, a legal problem requiring investigation and accountability, as happened with the S&L crisis, when a thousand people were successfully prosecuted. This time? Just about none, and no really big fish. Moral hazard has increased, and financiers are back to the old tricks and inventing new ones in their quest for loot, oh, excuse me, profit. Meanwhile, systemic risk is increasing rather than decreasing.

    The real capital requirement tightening we need is strict fiduciary responsibility for all intermediaries and personal liability in all financial transactions, as it partnership.

  6. Diogenes

    Yves writes: “In the stone ages of investment banking, when firms were partnerships…”

    Ahh, for those golden days of old fashioned capitalism.

    Having watched the investment banking industry evolve from 1982 to 2008, there is no question in my mind that the increased reliance on public equity (i.e., the trend during which all of the familiar Wall Street banking partnerships ended up going public) steadily fueled a shorter and shorter time horizon for those in charge. The result was more and more high risk decisions where, using the miracle of present value mathematics, traders and bankers could command huge upfront paydays by constructing complex, long term trades with very opaque long term risks. As we now know, those trades were very often based upon assumptions that were later proved to be completely fallacious. But the fact that not one dollar of the bonuses those busted trades generated has had to be paid back has pretty much etched in stone the reality that the system, as it currently still operates, is a “heads I win, tails you lose” proposition for the folks who make decisions about risk and return.

    It’s just human nature that people will do things with other folks’ money that they won’t do with their own. Which leads me to a natural conclusion that ought to be self-evident: In addition to separating the investment banking and commercial banking functions once again (and, in so doing, removing any public safety net from the investment banking portion), I believe our government should consider imposing a requirement (perhaps not unlike the restrictions which law firms are subject to) that entities functioning as investment banks must not be publicly traded companies. My understanding is that the hedge funds (to choose one example) have been able to do reasonably well without having to tap either the public equity markets or the Fed. Of course, the folks who run these operations still operate more or less under the romantic notion that free market capitalism isn’t a game rigged for insiders but one in which smart money beats out dumb money. From what I can observe, private capital seems to be a whole lot more self regulating than public capital.

    If I am right, isn’t there a lesson to be learned from all this?

    1. Jim Haygood

      ‘My understanding is that the hedge funds (to choose one example) have been able to do reasonably well without having to tap either the public equity markets or the Fed.’

      The sole exception which comes to mind is the Long Term Capital Management fiasco in 1998, which brought the Fed running to the rescue.

      Arguably a repeat of LTCM-style systemic risk could be avoided by regulation rather than by post facto bailout.

  7. Jim Haygood

    Let’s face it, the notion that we are going to have adequate private sector equity in the banking system anytime soon, if ever, is a fantasy.

    This being the case, why would Ben Bernanke imagine that more excess reserves will encourage bank lending (see above post regarding QE)?

    Plain-vanilla commercial and consumer loans require risk-based capital backing; sovereign debt is privileged by requiring less. Why is it such a mystery that banks are loading up on reserves and sovereign debt, instead of lending to the private sector?

    With regulators requiring highly publicized stress tests, even banks with excess capital may be disinclined to compromise their cushion by expanding their loan book.

    In aggregate, is the banking sector not more capital-constrained than reserve-constrained (if, indeed, it is ever reserve-constrained)?

    And if that’s the case, what on earth was Ben Bernanke babbling about at J-hole on Friday? Is this supposed to be some kind of joke?

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