More on the Lunacy of the Basel Accords

I was looking at the preferred asset classes under the Basel Accords in my previous post, and realised that every single asset class that is given less than a 100 percent credit risk weighting is now tainted by widespread default or impairment.

The credit risk weightings mean that instead of reserving the standard 8 percent of capital in respect of a debt, the bank can cut that by the weighting applied to the asset class. Effectively, the reduction in credit risk weighting operates as a powerful subsidy to the borrowers and equally powerful incentive to over-leveraging the lenders.

As a baseline, all financial, consumer and corporate debt must be reserved at a credit rating of 100 percent of 8 percent, unless explicitly discounted. A weighting of 50 percent, for example, means that instead of holding $8 reserves on a loan of $100, the bank only needs to hold $4 of reserves. A zero weighting means they lend $100, but hold no reserves at all.

Mortgages get a credit risk weighting of 50 percent, and we all know how well the mortgage market is performing. Mortgages and mortgage backed securities became the largest asset classes globally in a matter of years thanks to the credit weighting subsidy and securitisation. If I recall correctly, our present long crisis started with the collapse of the sub-prime market and now all categories of US mortgages are impaired by the ongoing mess with MERS and fraudulent or missing documentation. Borrowing short to lend long brought down Northern Rock and many other over-leveraged mortgage banks.

Interbank debt gets a credit risk weighting of 20 percent. We’ve seen from the collapse of interbank lending that banks do not trust each other. At the same time, inter-bank exposures and credit derivatives mean that financial institutions are massively dependent on each other, such that bailouts are justified as essential to prevent systemic collapse. If Too-Big-To-Fail is predicated on the systemic impact of a bank’s failure on other banks, it would seem that the 20 percent risk weighting was and is unsound.

Government agency debt gets a risk weighting of 10 percent. Looking at Fannie and Freddie, and the serial scandals and bailouts they have occasioned over the past decade, it is hard to see how such a subsidy can be justified.

Finally, sovereign debt of Zone A states is zero weighted – no reserves required at all. Zone A includes any country in the EEA, full members of the OECD, or states that have concluded special lending arrangements with the IMF except that any state that reschedules its debt is excluded from Zone A status for five years.

So the current financial crisis started with bad mortgage debt, spread to bad bank debt, carried over into bad agency debt, and now encompasses bad sovereign debt. Each of these categories was given preferential capital weighting under the Basel Accords, and now all are hemorrhaging, open sores on the financial system and the stability of excessively indebted governments.

Not only did the Basel weightings encourage poor risk assessment, they directly contributed to the inadequate capitalisation of banks for the risks they assumed.

And yet, have you heard any regulator take responsibility for regulatory failures yet? I haven’t. In fact, I’ve seen no historic analysis of capital requirements, deregulation of credit markets, securitisation, derivatives, or any of the other regulatory policy innovations which should reasonably be matters for review in assessing the causes of the current crisis.

As the bankers and regulators do not seem keen to be reflective about their own policies and conduct, it’s hard to imagine that they can craft constructive reforms to make the system safer or more efficient in future.

I’ve downloaded the draft Basel Accord III, released this week, for leisure reading. Sadly, I’m trending to the view that all harmonised regulation is likely to end in disaster as it precludes independent judgement and sensible challenge to orthodoxy. Once something has been agreed by a big enough committee, it becomes impossible to question whether it makes sense. Ultimately the unintended consequences of incentives and distortions mean it won’t make sense, but by then it’s far too late to change course and break from the herd.

Originally published at London Banker and reproduced here with permission.

3 Responses to "More on the Lunacy of the Basel Accords"

  1. Per Kurowski   December 21, 2010 at 8:08 am

    I object Basel I, II and III.I strongly object what is basically the only pillar of bank regulations created by the Basel Committee in Basel I, II and III, namely having the capital requirements for banks to be based on perceived risk of default.First: All systemic bank failures in history have occurred only as a result of excessive lending to what is perceived as not-risky, and never because of excessive lending to what is perceived as risky, which makes these capital requirements counterfactual.Second: The market and the banks already discriminate against higher perceived risk by means of the risk-premiums imbedded in the interest rates, and so these capital requirements are just an extra layer of risk-aversion that hinders the banks to help the world to take the risks it needs in order to move forward.Third: Since needing less capital when doing business with the “less risky” makes the profitability of bank business with the “less risky” to shoot up to the skies, this causes the banks to forget or discriminate against the “risky”, such as the small businesses and entrepreneurs on whom we depend so much for the future generation of jobs.Ps. And the above does not even mention the problems of having empowered the credit rating agencies with a risk-information oligopoly.

  2. London Banker   December 21, 2010 at 4:38 pm

    @ Per Kurowski,I AGREE. I remember being told as a wee young central banker that the number one cause of bank failure was residential mortgage default. Despite “safe as houses” being a catch phrase for financial security, more banks have gone bust borrowing short in deposits to lend long mortgages than from any other cause. I mention this to substantiate that central bankers must have known that they were making a hugely “counterfactual” assumption (using your adjective) when they agreed Basle I risk weightings.What I have trouble seeing is how we regain a sensible regulatory policy from here with the system being run by the banks who have benefitted from huge over-leveraging and the regulators who have colluded in the policies promoting said over-leveraging. No one seems interested in considering whether they have got basic policy wrong just yet, which means that we have to go deeper down the rabbit hole . . .

  3. Per Kurowski   December 22, 2010 at 6:54 am

    “how we regain a sensible regulatory policy from here”As I see it that can only happen if we can force the Basel Committee into a public debate about the absolutely senseless regulatory paradigm they are following. I have been trying to shame them into a debate for a long time… but they just hole up in their hole silence is also assisted by for instance a Financial Times that refuses to forward the real questions we should be asking of the Basel Committee. time ago I commented to Lord Adair Turner, the Chairman of the FSA of UK, that he was behaving like a confused handicap officer on a horse-racetrack taking away the weights of the good runners (triple-As) and placing these on the bad runners or debutants (small businesses and entrepreneurs), without even informing the bettors and the bookies, and believing this would lead to a fair and good race. Lord Turner answered me he needed time to answer that… and it seems it is taking him more time than what he thought… absolute silence.