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:

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

Stressed VAR is still a "protractor in the jungle"

A Sober Look post from a couple of years ago discusses the issues associated with using rolling historical period Value at Risk (VAR). The approach has a highly pro-cyclical impact on bank capital. During periods of low volatility and generally high profitability for financial institutions, the historical VAR method allows firms to lower their capital usage. During periods of crisis and therefore high volatility, VAR forces banks to allocate higher capital for the same positions. As an example, for the same dollar equivalent position in a diversified portfolio of US equities, a bank would have to allocate 3 times as much capital in 2009 as it did in 2007. Yet in 2009 these equities were no "riskier" than they were in 2007 - in fact one might argue that the inverse is true.

Basel III attempts to correct this approach. The new paradigm for market risk capital is expected to more than double the current capital requirements (that's partially why EU banks will need to raise so much more capital). A large portion of this regulatory capital increase comes from SVAR - the "stressed value at risk". SVAR still uses the standard 99% confidence interval (one-tailed), 10-day holding period, and at least one year worth of data, but requires it to be "calibrated" to a stress period (such as 2008).

This is certainly an improvement on the existing methodology and should reduce the pro-cyclical nature of the approach. But since the Basel Committee did not specify the stress period, and in fact requires that banks consider multiple stress periods, the measurement is still open to interpretation. One for example could see a case where regional supervisors would choose different stress periods for the same asset classes. That would mean that the same asset held in two different jurisdictions could potentially require different capital requirements.

The broader issue here is that VAR, even if it's now SVAR, is still the preferred regulatory approach to capital requirements. Risk practitioners in the financial services industry (both on the "buy" and the "sell" side) have long preferred to apply stress testing/scenarios when analyzing risk for internal purposes. SVAR would not have captured the risks at many financial institutions going into 2008. Since regulatory capital requirements drove performance, in many instances internal stress scenarios were ignored. The gap between what should be a superior approach to measuring risk and what the BIS bureaucrats are using to determine capital requirements has not been closed. Aaron Brown at AQR put it well when he said:

"People have tried to change VAR in lots of ways to explore the tail, but VAR is really for the center risk. In the tails you don't have enough data, so you don't know if something is one in a million, one in ten thousand or one in a hundred. But auditors and regulators want precise tools for exploring the regions that you can't explore with precise tools. They want to take a protractor into the jungle – it just doesn't work."

In addition to SVAR, the market risk framework under Basel III will also add capital charges from the incremental-risk charge (counterparty credit), a new asset securitization charge, and the so-called comprehensive-risk measure (more on these new rules later.) Risk "management" departments at banks will now grow more bloated (and probably even less effective), just to keep up with all this.

SoberLook.com

The Volcker Rule would not have prevented bank failures

Further confirmation of risks to liquidity posed by the Volcker Rule came a couple of days ago in the Congressional testimony by the Securities Industry and Financial Markets Association (SIFMA).

The impact of the regulations will have broad implications. The ability of corporate issuers to raise capital in the U.S. by selling their debt securities is dependent on the availability of secondary market liquidity, which is largely provided by banking entities through their market making activities. We are convinced that the proposal will significantly reduce the liquidity of the secondary market for debt securities and is likely to have a profound and unintended adverse effect on our capital markets. The U.S. economy will be forced to bear both short-term and long-term costs associated with the reduction in market liquidity that will result from an overly restrictive interpretation of the Volcker Rule.

It is still unclear what the regulators are trying to accomplish with the Volcker Rule. The only two large US bank holding companies* that failed in 2008 were Citibank and Wachovia. In structuring CDOs these firms sold the lower rated CDO tranches (that had "attractive" yields) to investors. But in order to create these tranches, the banks had to also create massive amounts of "AAA" (providing "leverage" for the lower tranches to boost the yield). Since the "AAA" tranches had low yields, it was difficult to place them, so the banks retained many of these bonds. But rather than putting them on their balance sheet, they employed off balance sheet CP conduits and used the asset backed commercial paper (ABCP) markets to fund these positions. This was known as the "regulatory capital arbitrage" - a concept US politicians still fail to grasp. The failure of the ABCP market in 2007 forced these banks to take the "AAA" tranches onto their balance sheets which ultimately led to their failure. But all of these activities were meant to facilitate the CDO business and had nothing to do with "proprietary trading". Therefore the Volcker Rule in its current form would not have prevented bank holding company failures.

  SIFMA Testimony on Volcker Rule

* Note that WAMU failed because it was overextended on its mortgage loan portfolio (unrelated to prop trading), Lehman and Bear were not banks and failed because they could not roll their repo financing, and AIG was effectively an unregulated insurance firm, not a bank.

SoberLook.com

Impact of sovereign downgrades on bank capital

Last night's eurozone downgrade news from Standard and Poors was largely expected. Going forward however these downgrades may impact bank capital requirements for banks who hold sovereign debt. In particular for banks who use the Basle II standard model, the downgrades may increase risk weights for some sovereign bonds. A 100% risk weight means that a $100 holding (for minimum of 8% capital ratio) will require $8 in capital, while a 50% risk weight would require $4 in capital, and so on.

BIS (January 2001): The standardised approach is conceptually the same as the present Accord, but is more risk sensitive. The bank allocates a risk-weight to each of its assets and off-balance-sheet positions and produces a sum of risk-weighted asset values. A risk weight of 100% means that an exposure is included in the calculation of risk weighted assets at its full value, which translates into a capital charge equal to 8% of that value. Similarly, a risk weight of 20% results in a capital charge of 1.6% (i.e. one-fifth of 8%).

Individual risk weights currently depend on the broad category of borrower (i.e. sovereigns, banks or corporates). Under the new Accord, the risk weights are to be refined by reference to a rating provided by an external credit assessment institution (such as a rating agency) that meets strict standards. For example, for corporate lending, the existing Accord provides only one risk weight category of 100% but the new Accord will provide four categories (20%, 50%, 100% and 150%).

Basle II risk weights are determined using ratings - larger banks generate internal ratings while smaller banks tend to apply the "standard model".  Most regulators however expect to see some consistency between rating agency scores and ratings generated by internal models. Under these rules, the risk weights would change as follows:

1. Spain and Slovenia bond holdings may get adjusted from zero risk weight to 20%. Where in the past no capital was required to hold these bonds, now 1.6% capital charge would be applied. Spanish bonds in particular may have an impact as they are widely held by EU banks (not just eurozone).
2. Italy bond holdings may get adjusted from 20% risk weight to 50%. This could cause a material increase in capital requirements across the eurozone as well.  Capital charge would increase from 1.6% to 4%.
3. Cyprus and Portugal bond holdings may get adjusted from 50% risk weight to 100%. This is the biggest capital adjustment (4% to 8%) as the ratings move from "investment grade" to "junk".  Fortunately Portugal's bonds do not constitute a substantial portion of EU bank sovereign bond holdings.

There should be no impact from the France downgrade because those bonds would still have a zero risk weight (as is the case with US treasuries).  Also it is important to note that these capital changes may or may not take place immediately.  Each nation's regulator may have a different interpretation of the rules when dealing with a downgrade by a single agency and not the others. But this move by S&P makes further downgrades by other rating agencies far more impactful because banks applying these capital rules would no longer be able to ignore them.


SoberLook.com

Sovereign debt and the Basle rules - clearing up the confusion

There seems to be some confusion around the Basle banking regulation with respect to sovereign debt.  We want to take a quick look at two distinct concepts here: "risk weights" used to determine capital ratios and "liquidity ratio" used to make sure banks have sufficient short-term liquidity.

1. First let's take a quick look at risk weights for sovereign holdings. The matrix below outlines what the risk weights currently are for sovereigns, financials, and corporates based on what's called the "standard model" for risk weights. Some institutions apply "internal ratings" using models that have been approved by their national bank supervisor, but for discussion purposes, let's focus on the standard model.

The rule of thumb is that you take the "risk weight" shown above and multiply it by 8% (assuming you want at least an 8% capital ratio) to determine how much capital you need against this asset (that is how much leverage is allowed). The problem with European banks is that it was easy for them to accumulate a great deal of sovereign debt because in most cases there was no capital charge at all.

The lower rated paper would require 2%-4% capital vs. an equivalent rating corporate loan for example that would require the full 8%. That is why there is so much focus on sovereign downgrades as lowered ratings automatically increase risk assets of these banks without them even buying anything. And as paper moves into "junk" category the capital requirement increases could be quite sharp. Therefore Basle-III may adjust this matrix to make sure there is always some capital held against sovereign debt.  The transition process however will be painful.

2. Then there is the issue with sovereign debt for LCR (Liquidity Coverage Ratio), which is a separate Basle-III requirement. Below is a quick definition of the ratios from Risk:

The liquidity measures are split into two: the liquidity coverage ratio (LCR) and net stable funding ratio (NSFR). The former is designed to ensure banks have enough high-quality, liquid assets to survive a 30-day period of acute stress, while the NSFR is meant to eliminate funding mismatches by establishing a minimum acceptable amount of stable funding based on the liquidity characteristics of a firm’s assets and activities over a one-year horizon. This latter ratio is some distance away from being ready for implementation, some market participants claim.

LCR is already regulated and measured, but the full requirement isn't going into effect until 2015. To maintain sufficient short-term liquidity, banks would be required to hold a certain amount of "liquid" assets.

Businessweek: Basel’s so-called liquidity coverage ratio, scheduled to be phased in starting in 2015, requires banks to hold enough “high-quality liquid assets” -- predominantly cash and government debt -- to survive 30 days of stress. Only a quarter of 28 of Europe’s largest banks would comply today, leaving a shortfall of 500 billion euros ($670 billion), according to a Nov. 29 report by Kian Abouhossein, an analyst at JPMorgan Chase & Co. in London.

Typically those assets would be sovereign bonds, but recently there has been talk about permitting liquid stocks and corporate bonds to be applied to this ratio as well.  This is not a new issue:

CentralBanking.com (15 Jun 2011):  The French prudential regulator, Autorité de Contrôle Prudentiel (ACP), appears to be at odds with the Basel Committee on Banking Supervision over whether equity should be included in the liquidity coverage ratio (LCR). In an interview with Risk, Danièle Nouy, secretary-general of the ACP, expresses concern that the list of eligible assets under the LCR is too narrow and should be broadened. The LCR, finalised by the Basel Committee last December, requires banks to hold enough liquid assets to survive a 30-day period of acute stress – and stipulates that a majority of the buffer should comprise cash and government bonds.

This is certainly going to generate debate.  Ultimately both the capital ratio and the liquidity ratio frameworks will have an impact on sovereign debt quality and volumes held and traded by financial institutions.

SoberLook.com

The perverse impact of Value at Risk

Since we are on the topic of banks, let's take a quick look at Value at Risk (VAR). It's a dollar measure used by banks to allocate trading limits as well as a tool regulators use for capital requirements on banks' trading activities (under the Basel Accord). In principal it is meant to measure the level of risk (potential losses) in a portfolio.

In practice however it a simply function of historical volatility that an existing portfolio would have experienced if one held it intact over some historical period (such as 2 years). There has been debate and academic literature on the topic (see references) ad nauseam, particularly on what type of VAR constitutes a more "accurate" measurement. In fact some sadly refer to the VAR calculation process as "risk management". But in the end it just comes down to one thing: VAR is very much linked to some form of historical volatility.

Under the BIS requirement, most use a 2-year historical period (or some other fixed time period). And therein lies the problem. The historical period deployed may be capturing a time of relatively low volatility, resulting in a risk measure that is considerably lower than the actual risk in the portfolio. And as long as the business understands the limitation of such a measure, there is no issue. But when banks allocate capital and set limits based on VAR, it can have all sorts of unintended consequences.

Below is a VAR measure over time on a $10 MM position in S&P500 based on a two-year rolling window (for each day it looks back to what the volatility was in the previous two years). If the period happens to be over a mild volatility range, the VAR measure becomes skewed to the low side.



In the middle of 2007, this chart shows VAR on the position that is over three times lower than the VAR on the same position now. That is for the same VAR limit a trader could have over three times as much in S&P500 as she can now. It is truly a perverse way of thinking about risk, as it lulled banks in 2007 into increasingly large positions. A $10 MM position in S&P 500 is probably no more or less risky now than it was in 2007 (many would argue that in 2007 it was more risky, rather than a third the current risk).

As historical volatility became lower, the capital requirements to hold the same trading positions gradually dropped, allowing banks to take on more risk. Now a two year period includes 2008 and everything looks extremely risky. But here is the kicker. As the second half of 2008 moves out of the two-year window (which will happen in the fall of 2010), the VAR measure will drop again assuming volatility stays mild (as it has been recently). And bank capital usage will drop allowing them to take on more trading risk.

It is mind-boggling to see regulators so committed to such capital requirement techniques. In effect this approach is a path to building asset bubbles. Banks increase risk (inflate the bubble) when volatility is low because they have excess capital. But they are forced to rapidly reduce risk (pop the bubble) when volatility increases because their capital requirements go up. But it's exactly during those periods of high volatility when banks don't have enough capital, forcing rapid unwinds and increasing volatility even more.

The holes of the BIS rule book

At Sober Look we always appreciate your e-mail. It's part of what makes Sober Look what it is - everyone's view counts. An e-mail came in at 2:45 this morning that was nearly 20 pages long from Mr. Anonymous. Thanks for the e-mail Mr. Anonymous. It was difficult to connect all the various stories of the e-mail, but the beginning was a classic:

"with your luxury of anonymity...rebut this:

"The Hidden Beginning" by Bruce Wiseman: On April 2, 2009, control of the planet’s banks was turned over to the secret decisions of eleven men—board members of a Swiss organization with a troubling Nazi past..."

Hmmm. Only 11 men? No women? Seems Bruce Wiseman is talking about the Bank for International Settlements or BIS. The BIS board members are in fact the central bankers from various nations. With regard to the 11 men, seems we have a few more these days (here is a quote from BIS):

"The Basel Committee on Banking Supervision decided to broaden its membership and to invite as new members representatives from the G20 countries that are not currently in the Basel Committee. These are Argentina, Indonesia, Saudi Arabia, South Africa and Turkey. In addition, Hong Kong SAR and Singapore have also been invited to become members. The Basel Committee's governing body will likewise be expanded to include central bank governors and heads of supervision from these new member organisations.

With its current expanded membership, the Committee is now comprised of representatives from Argentina, Australia, Belgium, Brazil, Canada, China, France, Germany, Hong Kong SAR, India, Indonesia, Italy, Japan, Korea, Luxembourg, Mexico, the Netherlands, Russia, Saudi Arabia, Singapore, South Africa, Spain, Sweden, Switzerland, Turkey, the United Kingdom and the United States.

The newly expanded membership will enhance the Committee's ability to carry out its core mission to strengthen global supervisory practices and standards. It will also help to more effectively implement the necessary reforms of the international financial system. "

The mission is in fact "to strengthen global supervisory practices and standards". Among other things, these folks are known for what's called the Basle Accord. Basle set the standard for determining the amount of capital banks should hold. The local central banks would make adjustments for financial institutions within their jurisdictions, but in general followed the capital rules of the Basle Accord.

Driven by academics, the organization strives to bring a near scientific sophistication to bank capital rules. Their big achievement was to assign capital requirement for "trading book" assets (as opposed to banking books). The formula was a multiplier times the value at risk (at 99% confidence interval and 10-day holding period). Sexy hah? Banks spent hundreds of millions implementing and complying with this - trying to bring all of their trading positions into a single VAR number every day. Then they would multiply this number by the multiplier (which usually was between 3 and 5 as assigned by their local regulator) to get their capital requirement. All nice and scientific.

The "banking book" was however another matter. It's harder to "model" a bunch of corporate loans. So under the first accord, the formula was simple. You have a corporate loan on the books, you compute 8% of the face value, and that becomes your minimum capital requirement. That was it until the newly minted Basle-II accord that bases banking book capital requirements on ratings either internal or better yet rating agency ratings. Isn't that special? Basle-II is still being implemented by a bunch of banks.

But most banks were still under the original Basle accord as we were entering the crisis. The bulk of the capital requirements for banks was coming from the banking book (loans originated by the bank). Let's look at an example: as a bank you lend to a corporation at LIBOR + 1% - for a strong corporate credit. You borrow at LIBOR in the interbank market. So your income is 1% of the loan face, and according to Basle, you have to put up a minimum of 8% in capital. Most banks wanted to put up more than the minimum to keep their regulators happy and the stock analysts shouting "buy!". So most had some 10% or more in capital. But that's a bit of a problem. Your return on capital is now 1% (income)/10%(capital) = 10%. 10% return on equity is way too low. Shareholders wanted more, way more.

The banks needed a loophole and one was readily available from BIS. The capital requirement drops dramatically to a fraction of the 8% if
1. Your corporate loan is unfunded - that is it's an unfunded commitment or a guarantee.
2. The commitment (above) is under a year in length.

So how do you get a 7-year loan to satisfy the requirements above? The answer is what's called a "Commercial Paper (CP) Conduit". You create a company and gift it to a charity. That company will do the lending instead of the bank. It will fund the lending by issuing commercial paper, short-term obligations (under a year). But why would anybody buy this commercial paper? Because the bank would provide a guarantee (that satisfies the two requirements above).

Based on that guarantee, the rating agencies would give the commercial paper a high rating, making it marketable to money market funds. In return for the guarantee, the bank would get to keep most of the spread, the difference between the loan interest and the commercial paper cost (with a sliver going to the charity who owns the CP conduit). Now the bank makes the same income, but on a loan that is not on it's balance sheet (the loan is on the balance sheet of the CP conduit owned by a charity). The bank's only capital requirement is based on that guarantee to the conduit, which is under a year and unfunded. Capital requirements are now closer to 2% rather than 8%, catapulting the return in our example to 1%(spread)/2%(capital) = 50%.

Now we are talking. Let the charity do the lending, the bank provides a guarantee and gets massive returns. The shareholders are happy, the charity is happy, and the regulators are clueless. This was called Regulatory Capital Arbitrage. Clever hah? While BIS and the regulators focused on VAR for the trading book, the banks ran a shadow bank on the side and pumped up returns. All perfectly legal, all within the BIS rules.

Of course it wasn't just the corporate loans that went into these CP conduits (there is only so much corporate lending a single bank can do). It was also the senior structured credit bonds, securitized by mortgages (mostly subprime mortgages with a nice yield) and other consumer loans. The same trick: CP conduit buys the bonds, issues commercial paper, bank provides a guarantee, gets low capital requirement. The tighter the spreads became the larger the size and the number of the CP conduits. Hundreds of billions.

Then in 07 the music stopped. As subprime default rates picked up in early 07 (a story for another day), the commercial paper (CP) buyers got nervous. Since CP is a short term loan and needs to be rolled every 1-6 months, the buyers all of a sudden said... not this time. With no commercial paper to finance the assets, the guarantees from banks kicked in, forcing banks to fund all the assets in the conduits directly from their balance sheets. But remember, based on BIS rules, banks only had a couple of percent in capital against these assets (50 x leverage). And now the banks owned these assets directly, as the values kept deteriorating. Most of these were (or became) highly illiquid assets. We all know what happened next.

Banks followed BIS capital recipe precisely and found themselves massively under-capitalized (or overlevered). It was all legal and by the book, the BIS book. Thus in many ways BIS (together with a bunch of factors we plan to discuss later) may be responsible for the financial crisis. So Mr. Anonymous, back to your e-mail. The control of planet's banks was not turned over to BIS on April 2, 2009. Unfortunately the control got turned over to them much earlier (back in the 90s), as the national regulators increasingly relied on Basle to keep their banks properly capitalized. Our only hope is that going forward, bank regulators use some common sense and ask fundamental and practical questions, rather than blindly putting their faith in a rule book devised by a bunch of academically minded bureaucrats in Switzerland.

Update from Mr. Anonymous:

"Perhaps you could clarify for your readers that I was the messenger not the author. Although the temptation for ad hominem attack was mistakenly directed at me I appreciate the time you took to write your very instructional clarification of Wisemans piece."