Criticizing Basel for the Wrong Reasons

Guest post by Jasper Tamespeke


This has been bugging me after some of your recent articles, but what prompted me to write was your post today Steve Hanke criticizes Basel III for the wrong reasons (see post). I think he might be right to some extent, but I believe both of you are wrong on the big picture. You implicitly assume that the problem is moving to Basel III: however, staying put on Basel I is not really an option. The problem is rather with the whole Basel project itself.

First, the extent to which Hanke is right: you point out that US Banks are currently well capitalized so the compliance with Basel should be less of a problem. That might be true if one were just to compare current tier 1 ratios with the new Basel minimums (4.5% core tier 1 plus 2.5% buffer, etc) but there are 3 other considerations:-

• There are going to be many new deductions which can quickly cause capital to evaporate, such as for pension deficits, deferred tax assets, and particularly important for US banks, mortgage servicing rights
• Basel III is not just adjusting the numerator of the Cooke ratio, it is also going to massively inflate the denominator. The huge increases in RWAs in the trading book in particular, in both Basel 2.5 and III, will hit banks with any investment banking businesses very hard.
• The 2 new liquidity metrics will require banks to hold more liquidity and will act as a constraint on new on-balance sheet lending. This could severely restrict maturity transformation.

Exercises on European banks 10-12% Tier 1 capital ratios at the end of 2010 or 2011 (and, yes, there are some), which superficially look like they should have no problem, end up with a deficit or barely enough capital when all this is taken into account.

You are also right to bemoan the complexity and micro-management of Basel III (and II), but that is attacking the symptom rather than the cause. This second-guessing of risk management down to desk and deal level is the inevitable consequence of global risk-based capital rules.

Basel I was implemented in the late 1980s to try and increase capital levels in banks throughout the major economies, and to create a more level playing field in international markets. In both these aims, it was in the short term very successful: capital levels did increase across the world economy.

However, Basel I was a short term fix; it is very crude and creates perverse incentives. As well as being too lenient on securitization that does not truly transfer risk, it incentivizes banks towards trashing the quality of their loan books. For example, all corporate loans attract a 100% risk weight (i.e. require $8 of capital for every $100 lent) , regardless of whether the loan is to Microsoft (AA+), or Dynegy (CC). So lending to high margin risky names creates a better return on capital.

The point that the critics often miss is that Basel I is broken. This is why we got Basel II: if we are to have risk based capital rules (and that is the big if), then we need to discriminate between credits. If we want to discriminate between credits, what alternatives are there? Well there are the Rating Agency ratings, or internal bank ratings and …. er….. that’s it. This is the point that the critics need to address: what else would you do? Sticking with Basel I is clearly not a safe option either.

The situation with straightforward lending is bad enough, but it gets much worse with more complex products, but this outcome was inevitable given the starting point. If we have risk-based capital rules, then the regulations will have to try to cover the risks in more and more detail, playing catch up with the banks and other institutions, which will always evolve and adapt faster than the rules can. With each iteration, they create ever greater market distortions. And then there is the problem that these rules are applied globally, so institutions everywhere will adapt to the rules in the same way, which in a crisis will probably not be a good way.

These 2 issues (a) risk-based capital requirements and (b) global capital rules are the main problem. The Basel project seemed like a good idea in the mid 1980s but the monster that is the combination of Basel II, 2.5 and III is the logical result. Simpler, nationally grounded regulation which allows banks to compete and fail without threatening everybody’s taxes may seem like going backwards but maybe progress isn’t always such a good thing.

SoberLook.com

From our sponsor:

US Basel III implementation delayed; called "same complicated system for judging risk that failed in Basel II but with more complexity"

As discussed before (see post) Basel III implementation carries significant costs. In the US the implementation has its unique problems (discussed here). The approach hits securitization particularly hard, making ABS (short maturity credit card and auto loan paper) tougher for banks to hold - yet encourages banks to hold more sovereign debt (less capital required to hold Italian bonds than a pool of auto loans for example). Also small businesses that are not rated will have a tougher time obtaining loans because such loans will require more capital. In fact a portion of small business lending will shift to non-bank entities such as mezz funds who will charge higher rates. To add to the fiscal cliff worries, US bank regulators were going to impose Basel III rules at the start of 2013. Luckily that deadline has been pushed back, as concerns grow about this new set of rules.

WSJ: - While taxpayers wonder if Washington is going to throw them off a cliff of scheduled tax hikes, another potential economic calamity has been postponed. On Friday, bank regulators announced that they will not impose complicated new rules on New Year's Day. Let's hope they don't impose them on any other days.

The Federal Reserve, Federal Deposit Insurance Corporation and Comptroller of the Currency issued a joint release saying they will no longer require U.S. banks to follow the so-called Basel III capital rules by January 1. Created by a college of global bureaucrats who enjoy meeting in Switzerland, the new rules are brought to you by the same people who encouraged banks to load up on mortgage risk before the panic of 2008.

Their new rules encourage banks to load up on sovereign debt. This makes perfect bureaucratic sense, since the world's governments have proven to be hands-down the issuers with the most dishonest accounting.

The US is not the only country concerned about Basel III. The impact on the US is actually expected to be smaller on a relative basis than on a number of other nations' economies. Asian nations will see the largest impact, particularly South Korea. In Europe, Switzerland ("CHF" in chart below) will be impacted the most, in part due to Credit Suisse (see discussion).

Peak Impact of Basel III on GDP (source: Barclays Capital) 

In the US the issue is not as much the higher capital requirements (US banks are already well capitalized) as it is with the rules themselves - which artificially penalize some risks but not others. The WSJ article summarized the situation with Basel III quite well (it would be interesting to find out who on the WSJ staff actually wrote this story):

WSJ: - The FDIC's own Director Thomas Hoenig sees in Basel III the same complicated system for judging risk that failed in Basel II "but with more complexity." Using theoretical models that have failed in practice, the rules assign "risk-weights" to different assets, divined by an almost endless series of calculations. For the largest banks with the resources to spend on regulatory arbitrage [see discussion], this is an opportunity to get risky assets officially designated as safe.

But the cost of this complexity, and the burden it will place on small banks in particular, is no doubt a big reason why the feds have taken a step back from the regulatory cliff. In their Friday note, the bank overseers said they were moving back the deadline "in light of the volume of comments received and the wide range of views expressed during the comment period."

Certainly a wide range of negative views have been expressed, including by the Bank of England's Andrew Haldane and Vasileios Madouros. Their research shows that Basel's intricate models were hardly of any use in predicting which giant banks would fail during the crisis. This should surprise no one. The essential function of the Basel Committee is to strike political compromises among global regulators, who have rarely been confused with the best and brightest minds in finance.

SoberLook.com

Why Basel III won’t work

After the Ferbruary post on the flaws of Basel III regulation (see discussion) we got a number of emails pointing to the importance of uniform global banking rules. "By criticizing Basel III you support these banksters" was one of the comments. Of course the wrongs of banking could be set right by new rules - even if they are a messy modification of an earlier set of regulations that got large banks (like Citi) into trouble to begin with (see discussion from 2009).

But many professionals in the financial services industry continue to support Basel III, in part because it benefits them. Most people don't fully appreciate how much business the major international accounting/consulting firms for example get from engagements to implement new capital rules at banks. That's why it's no surprise that many advocates of (and experts on) this "enhanced" regulation just happen to be consultants from the Big 4 and other large accounting firms. Nothing wrong with consulting, but there is a bit of a conflict here.

Clearly some of the new rules are important - particularly those dealing with adequate liquidity. But the prescriptive methods used to solve every possible concern dealing with capital and liquidity will push financial organizations to focus on the "letter of the law" instead of the "spirit of the law". And loopholes will inevitably arise (as they did with Basel I) creating more systemic risks.

Some of the problems with Basel III are laid out in this excerpt from a well written article on Bloomberg Brief. The implementation issues emerging from the new regulatory framework are troubling indeed.

Karen Shaw Petrou (Federal Financial Analytics): - ... Basel Committee rewrote its capital book in 2010 and, for good measure, added needed global liquidity standards.

Two years later, though, and each of these axiomatic standards remains unimplemented in almost every major banking center. Some have suggested that, with just a bit more gumption, the Basel rules will jump national borders to conquer risk. But, like it or not – and I don’t much like it – Basel can’t work.
...
The global capital and liquidity standards codified as Basel III have important weaknesses of their own – most important among them undue complexity resulting from a hopeless effort to address every nuance in each major banking market under each applicable accounting scheme in all circumstances. But, even if Basel were better, it couldn’t be consistently implemented in comparable fashion across borders no matter how well meaning the national regulator.

The reasons for this are statutory and structural. First, many nations – the U.S. is a prime case – have laws that override key tenets of Basel III. For example, the U.S. bans reliance on credit ratings, which means that its risk judgments are substantively different from those that underpin Basel III. The European Union is considering a law that side-steps implementation of the Basel leverage ratio – a critical reform meant to prevent all the risk-weighting games still shockingly evident across the globe. And, even where law permits imposition of Basel’s key provisions, it often doesn’t let supervisors actually enforce tough capital rules – mooting the point.

And, even if there weren’t these statutory barriers to Basel III, profound structural ones bar comparable crossborder capital and liquidity standards. One of the most important here is the U.S. commitment to community banks, for which Basel is in many ways inappropriate. Even if one carved out community banks, the U.S. still has 34 bank holding companies with assets over $50 billion, a sharply different and more diverse banking system than found almost everywhere else.

Even more significant, the U.S. now has a combination package of statutory and structural barriers to Basel III. The Dodd-Frank Act created an “orderly liquidation authority” (OLA), a new law that will end too big to fail by barring taxpayer support for large banks. In sharp contrast, the European Union and many other nations have banks that are not only backed by too big to fail, but also “too big to save” expectations by virtue of national reliance on only a very few, very large banks.

SoberLook.com

Unintended consequences: the new regulation will hurt the US corporate bond market

In their effort to remove proprietary trading from bank holding companies and increase capital requirements, regulators are destroying liquidity in the US corporate bond market. If you make markets (offer to buy and sell) in any product that has limited liquidity, you must run inventory. Baseball cards, antiques, or bonds - it's the same process. However between Basel III and the Volcker rule, the ability to maintain inventory is being undermined.

Barclays Capital: Increased regulation is a primary cause of this shift in dealer behaviour, in our view, in particular Basel III and the Volcker rule. Basel III significantly increases the risk-weighted assets associated with dealer balance sheets, thus making holding inventory more costly. Several banks have cited this change when noting material decreases in their fixed income balance sheets. For example, Credit Suisse announced that it plans to nearly halve the Basel III risk-weighted assets in its fixed income division over the next three years. Uncertainty about the implications of the limitations on proprietary trading included in the Volcker rule have also led dealers to reduce inventories. While the rule-writing process on that front is still ongoing, absent some substantial unexpected changes, the trend will likely continue towards reduced capital devoted to market making.

The dealers have started pulling back on inventory ahead of new regulatory framework   The chart below shows the levels of dealer inventory of corporate bonds, both High Yield (HY) and Investment Grade (IG) vs. mutual fund holdings.

Mutual funds tend to be "buy and hold" investors. Therefore price discovery in the corporate bond market comes from transactions facilitated by dealers or dealer quotes. As dealer inventories drop, transaction volumes decline and bid/ask spreads get wider.  In other words if you can't add bonds to you inventory or have no bonds in your inventory to sell, you will have to find the other side of the trade before you can transact.  If you don't have the other side of the trade ready (and usually market makers don't), you will make markets wide enough to compensate you for the risk of finding the other side later to unload your position.

Another troubling "unintended consequence" of the upcoming regulation is increasing concentrations.  Dealers will only make markets in the largest, most liquid names because the smaller names would not justify the capital usage in the new regulatory framework. The next two charts show the transaction volumes for HY and IG bonds sorted from highest to lowest.  The most liquid few issues account for the bulk of the volume.

Investment Grade

 

High Yield

Barclays Capital: As dealers shrink their corporate bond holdings and mutual funds demand higher liquidity, we see an increased risk of volumes becoming even more concentrated than they are currently. Indeed, in the first three quarters of 2011, of the nearly 628 tickers in the U.S. Corporate Index, the 37 most liquid credits accounted for 50% of the volume; only 10% of the volume was in the bottom 412 tickers (Figure 16). The volume concentration is even more pronounced in high yield – 50% of the volume in the first three quarters of 2011 was in 46 tickers (out of 1,140), with the bottom 821 tickers accounting for only 10%

Who cares, you might ask. It's the medium-size businesses who are going to get hurt. Because liquidity in their bonds is going to dry up, investors will become concerned that they would not be able to sell these bonds when they need to do so. Therefore they will demand an increasingly higher yield to purchase such bonds (liquidity premium). And the medium size business - who tend to create a great deal of new jobs - will be the ones paying significantly more to borrow money.

SoberLook.com