The Truth About Sovereign Defaults and Bank Capital

A foolish consistency is the hobgoblin of little minds, adored by little statesmen and philosophers and divines. – Ralph Waldo Emerson

When historians of the future look objectively at the era preceeding this long financial crisis, they might well conclude that failure of the globalised capital system is traceable to the Basel Accords. The unreasonable assumptions and myriad distortions introduced in this one-size-fits-all paradigm of bank capital adequacy fatally undermined the practice of independent judgment in assessing credit risk and prudential supervision of banks.

Bankers of the past had to assess the creditworthiness of a debtor or counterparty based on balance sheet, revenue potential and management reputation for competence. They husbanded their scarce capital, aware that each dollar lent remained at risk until repaid, with cash reserves proportional to the bank’s assets usually 8 to 10 percent.

A primary fallacy of the Basel Accord is that OECD government debt is risk free and requires no bank reserves. Better yet, the banks can count the government debt they hold as Tier 1 capital, reserving against other debt assets. The Basel Accords assume all OECD government debt is a cash proxy, being liquid in all market conditions.

Walter Wriston’s 1970s dictum that “sovereigns can’t default” was disproved in the Third World Debt Crisis of the 1980s, but somehow the BIS Committee on Bank Supervision still embraced it when applied to OECD state debts.

Roughly, the risk weights of the main asset classes under Basel I were:

– zero for Zone A (OECD) government debt of all maturities and Zone B (non-OECD) government debt of less than one year;

– 20 percent for Zone A inter-bank obligations and public sector entity debt (e.g. Fannie Mae, Freddie Mac, et al.);

– 50 percent for fully secured mortgage debt;

– 100 percent for all corporate debt.

The post-Basel bank supervisors applied their prudential supervision models unthinkingly, to rubberstamp the bankers’ leveraging of their balance sheets toward ever greater excess. No one bothered to ask whether Basel Accord assumptions made sense. They were the harmonised norm for prudential supervision and too deeply embedded in the fabric of international finance to adjust, except to allow more and greater leverage in Basel II. Basel II allowed the banks to offset even more risk exposure with even less capital through collateral, credit default swaps, and recognition of the validity of internal asset valuation models.

Global harmonisation of prudential supervision around the Basel Accord meant that the hobgoblin of excess leverage became systemically entrenched in all markets, in all nations. The foolish consistency of harmonised capital adequacy was adored by little minds of global bankers and central bankers worldwide.

The zero weight for OECD government debt must have appeared a harmless subsidy to OECD governments in 1988, promoting liquid government debt markets and enhancing the competitive positioning of OECD-based global banks who stood to gain most from the harmonisation of global bank regulation and capital rules.

Leveraging their balance sheets to work every dollar of capital harder became the obsessive preoccupation of two generations of bank executives once the Basel Accords were adopted. Risk management departments were less about controlling exposure to adverse credit events than about identifying deal structures which would minimise the amount of regulatory capital allocated to any exposure.

Fannie Mae, Freddie Mac, and their ilk were an early mechanism to reduce the reserves required from 50 percent on an individual mortgage to twenty percent or even zero, allowing the banks to write more and more mortgages with less and less capital. When these entities proved inadequate in the go-go 1990s, asset back securities allowed banks to get sub-prime mortgages – and thereby the capital requirement – off their books entirely, passing the risks to yield-hungry investors. With Basel II they could reduce capital even further by writing each other a daisy chain of credit default swaps for all categories of exposure. Who could have known that it would end badly?

OECD government debt is zero risk weighted and accounts for a disproportionate bulk of Tier 1 capital of major banks. A default by any OECD government will force banks and central banks to recognise that government debt has inherent risk like all other debt. This would force recognition of a positive risk weighting, and bring into question the assumption that government debt can be counted as a cash-proxy in Tier 1 reserves. The illiquidity of impaired or defaulted government debt would undermine its role as a Tier 1 reserve asset in bank capital models.

At this writing the OECD governments at risk of default are Greece, Portugal, Spain and Ireland, with other states queuing up in the wings. Already the ECB is the only buyer in the market for much of the impaired government debt.

If any OECD state were to default there would be very serious implications:

– The Basel Accord zero risk weight of government debt in Basel Accord calculations would be proved fanciful;

– The assumption of government debt as a liquid asset suitable for bank Tier 1 reserves to meet unanticipated and sudden cash demands will become unsustainable;

– Banks would be forced to recapitalise at much higher levels, forcing even sharper deleveraging and contraction of lending;

– Governments would lose the captive, uncritical investor base they have relied on to finance excess public expenditure for the past 30 years;

– Central banks could be forced to suddenly monetise even more government debt if required to meet the cash demands of a run on their undercapitalised banks.

Looked at this way, you should be able to understand why the ECB keeps repeating that there can be no Eurozone sovereign default, and why the UK and US are staunchly behind them in preserving the illusion of state solvency for all Eurozone states.

It will likely prove impossible to reform the bankers and central bankers dependent on the Basel Accords for their business models and careers. Harmonisation of global standards was supposed to make the world safer. A foolish consistency on bad policy and bad practice led instead to a world on the edge of financial implosion.

This hobgoblin haunts us all.

Originally published at London Banker and reproduced here with permission.

One Response to "The Truth About Sovereign Defaults and Bank Capital"

  1. London Banker   December 13, 2010 at 2:21 pm

    Why isn’t anyone commenting here? Where have all the commenters gone? For those that don’t remember, Professor Roubini promoted me to blogger from the comments section on economonitor, but I’m still missing the give and take of comments exchange.