New Basel III Accord On Bank Capital A 50 Percent Solution, Exposes Us To New Crisis
The Basel Committee has delivered new standards for bank capital, but they fail to tackle a key driver of the crisis: the quality of a bank's loans.
Yes, the new so-called Basel III accord is one of those topics designed to calm hyperactive children, but consider this quick lesson. The Basel Committee has created a new, higher required ratio of capital to assets, and much commentary is focused on the capital banks will have to raise as a buffer against future crises. Felix Salmon, always into the wonky details, gets into Basel III today in impressive detail on the capital side of the equation. And yes, it would be a good thing if banks had more capital on hand.
But what about the assets?
We got into a financial crisis because the assets went south, and what was full of worth suddenly became worthless. We ought to be thinking about how regulators treat assets on a bank's balance sheet. There are two sides to this coin, something surely a banker ought to understand. (In fact, they may very well understand this, which is why I wrote some time ago that Basel is the place where financial reform could die if we're not careful.)
The Basel Committee speaks in terms of "risk-weighted assets," and that ought to be a warning sign to all of us. It means that not all bank assets -- the loans it makes -- are treated equally. The better the perceived quality of the loan, the less cash the bank has to sock away as an insurance policy. The problem is, as well all know, perceptions can change mighty quickly in a crisis.
To grasp the shortcoming here, you only have to appreciate the following fact. If a bank loans money to a business, it has to tuck away a percentage of that loan amount -- about 8 percent here -- as a hedge against default. If a bank loans money to a sovereign government by buying its bonds that has a rating that is less than AAA, it has to lay away precisely zero. Uh, anybody heard of Greece? How about Portugal? Spain? Even Ireland! Yes, sovereign bonds can drop in value. In fact, Greece will in all likelihood apply a haircut to its bondholders. (I won't even begin to get into what would happen if a bank buys, say, subprime mortgage-linked bonds that are rated AAA!).
How it came to this, I do not know. Smart voices like Harald Benink of the Tilburg University in the Netherlands and the Shadow Financial Regulatory Committee have been making this point for some time, and arguing that new rules need force banks to value assets on a "non-risk-weighted basis." Did bank lobbying carry the day?
Eye-glazing stuff, I know. But there's a big hole in our new financial regulatory framework. Made in Basel.
UPDATE:
After I wrote this post, I spoke to Benink who pointed out that Basel III only took up the question of risk weightings related to a limited universe of financial products (such as the infamous mortgage-backed securities). But he told me something even more disturbing. After Basel II was created in 2008, the banks weaseled their way out of its strictures by tweaking the risk weightings in their favor. So, he expects more of the same with Basel II. "To what extent can the banks reduce the risk weightings? There is all sorts of potential regulatory capital arbitrage. The banks will try to figure out what they can do."
As I said, a big hole in the framework.
Image from Sapphireblue via Flickr
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