Basel Bank Capital Rules: Time To Dump Them?

The mortgage mess and great recession here in the U.S. led to a great deal of additional banking regulation. Regulations are made by people who usually do not have enough awareness of long-term consequences, so nobody really knows how these regulations will impact banking, the mortgage business, and the economy.

And on an international scale, we have yet another layer of regulation: the Basel accords, which try to ensure banks doing business outside their own countries are playing by the same rules. Since Basel is making headlines again, below I touch on a few key points about why these regulations don’t really make sense.

Before Basel, each nation had its own definition of how to calculate bank capital and what constituted adequate capitalization. There is a Basel I, a Basel II and a soon to be in effect Basel III. In this piece, I am referring to Basel II when I say “Basel.” My criticism of Basel II also pertains to Basel III. The entity which manages the Basel accords is called the Bank for International Settlements more commonly known as BIS.

Basel II requires all well-capitalized banks which operate internationally to hold capital greater than of equal to 8% of their risk weighted assets. Different assets classes have different risk weights: commercial loans are 100% risk, whole mortgages are 50% risk, GSE mortgage backed securities are 20% risk and government debt is zero risk.

The country most affected by the original Basel accords was Japan. Japan was having a real estate bubble just before Basel took effect. The real estate bubble in Japan was much better disguised that it was here. Japanese banks simply made new loans to replace non-performing loans disguising the size of the non-performing portfolio. The fact that the Basel accords kicked in when they did may be part of what Japan has has a stagnant economy for 20 years.

The issue really is this: are we better off with one set of banking regulations for all countries? Or would economies be better off if each nation decides its own standard for risk weighting of asset classes and capital requirements?

Basel has some standards which make little sense to me.

Commercial loans are, per Basel, 100% risk. But not all commercial loans have the same real risk. Worse yet, if Basel makes no distinction between risk for good or bad commercial loans then a bank might choose to lend money to a company with worse credit because it would get a higher interest. Also having commercial loans at 100% risk is a possible way to create an extended recession if banks stop lending money to businesses.

To me, the problem with Basel is that it is static.

It does not recognize that mortgage debt is riskier when there is a real estate bubble. It does not allow a change in risk weight for commercial lending when that lending might be expansionary and per se risk abating. Worse yet, Basel was partially responsible for the mortgage mess because it incorrectly assumed that MBS were less risky than whole mortgages.

Banks sold whole loans which they had made according to their own standards because Basel allowed them to hold MBS with 60% less capital. In effect, Basel more than doubled their losses because it did not allow that those MBS were crap. Banks were making PLMBS (Private Label Mortgage Backed Securities) and selling them to FNMA because FNMA could not generate as many bad loans as HUD demanded.

Basel made the enormously incorrect assumption that the risk of MBS was static. Instead of mitigating risk, Basel encouraged it.

What happened with the mortgage mess was that despite the good intentions of Basel and the good intentions of HUD no one saw the possibility that the result of their well-intended regulation not only failed to prevent a problem but actually helped cause it.

The notion that mortgage securitization minimizes risk makes perfect sense from a theoretical point of view.

The failure was that Basel made no accommodation for the disasters created by government mandated downgrading of the quality of GSE debt or Wall Street and the debt rating firms downgrading the quality other MBS.

Basel makes the incorrect assumptions that risk is static. It is not. Basel is, in a sense, a set of regulations for regulators and it failed to recognize that regulators can be just as wrong as bankers. Both bankers and regulators made cognitive errors. The story being constantly told is that the mortgage mess was due entirely to greedy bankers. While some bank losses were greed induced most of them were due to ignorance rather than greed. Some bank losses resulted from cognitive errors made as banks and regulators made incorrect assumptions about MBS. Failure to realize that the problem is not just greedy bankers or dishonest loan agents minimizes the complexity of the problem. It is imperative that if we want to prevent another such mess we understand what happened.

Basel now has an additional incorrect assumption. Basel treats sovereign debt as zero risk.

That may have been plausible before the Eurozone debt crisis. With Greece, Portugal, Italy and Spain all having debt issues requiring intervention, the zero risk rate assigned to sovereign debt per Basel is absurd. It sways banks to lend money to badly governed nations instead of lending it to companies and individuals who could use those loans to create economic activity. The fact that S&P could have questions the rating of U.S. Treasury debt this week shows just how bad the overall sovereign debt situation is. It is, to me, indefensible at present to suggest that all sovereign debt has no risk. Nations are rather dissimilar. Greece (the first to fall) is a nation with a history of political corruption.

In summary, Basel is built on a set of incorrect assumptions and we may be better off if we scrap the accords and have each nation let its central bank, the banks themselves and the legislated regulators work out what they believe is best for their nation. A competitive set of risks and rewards may be a lot better than the “one size fits none” mandate which result from Basel.