Don’t Believe the Basel Hype

“It’s a certainly not the easiest story to explain, but it’s hard to think of one of more importance to our future prosperity,” was the rather breathless judgement made by the BBC’s business editor, Robert Peston, to the news that the world’s central bankers had agreed a new set of rules to protect banks from another meltdown like the one of 2008. So what is this deal that, in Peston’s view, is “the most important global initiative to learn the lessons of the 2008 banking crisis and correct them”, that is so important that “if you can find me many stories in the past few days or months that matter as much, then I’ll acknowledge I’m living on a different planet from you”? Has Lady Gaga been made the head of the International Monetary Fund?

Peston is part of a media lovefest for the new Basel rules, an orgy of celebration for the work of one of the world’s dullest organisations, the Bank for International Settlements. Amongst all the media praise, the one small criticism to be heard – and it is certainly a valid one – is that the new rules will not take effect until 2015, and even then will be phased in over 8 years (a timeline that suggests to us that not even their regulatory authors regard them as essential in saving the world from another financial meltdown).

As Peston says, the new rules, known as Basel 3 (not, presumably, as a tribute to how succesful Basel’s 1 and 2 were), are pretty arcane stuff – but the essence of the deal is that big banks are now going to have to squirrel away at least $7 (and in many cases more) in their reserves for every $100 they lend or invest, just in case those loans/investments go bad.

The new rules also mean that regulators can insist on even bigger reserves for some banks, especially big “systemically important” ones, and at some times, like when the world economy is over-heating. If banks fail to comply, their shareholders will receive a slap through restrictions on dividends, whilst executive bonuses will feel the cold steel of the regulators’ axe.

On the face of it, this all seems jolly sensible – or, as our blogging friend Felix Salmon puts it in another triumphalist post, “very welcome stuff”. Back in those happy, bubblicious days before the financial crisis, banks were required to hold only $2 for every $100 they lent – although most held more than that, if less than the new Basel minimum – with the result that, because so many of them lent irresponsibly, they were short of reserves to cover their losses when these loans turned toxic. So, the logic goes, increase the size of the capital cushion, and a repeat of the financial meltdown is far less likely.

If only reality were so simple. Even with the lower capital requirements of the pre-crash era, banks often came up with clever wheezes to get around the rules – especially those that demanded more capital be set aside for riskier loans or investments. That was part of the attraction of securitization – it let banks make money on a deal, such as financing mortgages, and then shuffle most of what regulators regarded as the risk exposure to the loan (and thus the obligation to set aside capital against it) off their balance sheets and do it all over again. What’s to stop them doing something similar again? Yes, today the banks are all hunkered down being conservative with their lending, but that will pass with time. Yes, regulators will clamp down on the old tricks, diligently shutting the stable door after the horse has bolted – but you can bet your bottom dollar that the banks will be ingenious enough to find their way round the rules, especially as they won’t be fully phased in until 2023. After all, the financial resources of banks dwarf those of regulators, meaning they can always afford the best financial engineers, best lawyers, and best accountants, enabling them to stay a step ahead of those mostly less talented folk watching over them.

In The Road From Ruin we look at the lessons from centuries of financial crises. What is clear is that when there is money to be made, the financial sector will always find a way round the rules sooner or later. Like the Maginot line of forts that was supposed to protect France from another invasion which was bypassed by the Nazi blitzkrieg of 1940, the Basel rules are likely to be a poor defence against future risks.

Even if, to our surprise, the rules could be made stick, they might still provide no protection. What’s so special about keeping $7 for every $100 lent out? Nothing. In fact some countries, including the UK and the US, wanted a higher reserve requirement ratio of 10%. Not that 10% would make the banks safe. Lehman Brothers - the most famous casualty of the 2008 meltdown – had $11 of so-called “tier 1 capital” for every $100 it lent out when it went bankrupt. So how much would be enough? 20%? 50%? 100%? You may as well ask how long is a piece of string. It all depends on what the banks have lent to and what is going on in the rest of the market.

Faced with these problems, the Basel agreement’s supporters say that it is better than nothing and will, at least, make the financial system a bit safer. Well, maybe. But there is a real danger that these new rules will instead lull everyone into a false sense of security that 7% (or a little bit more) means safety.

We should also remember that these restrictions come with a cost – as banks keep more capital in their buffer, so they will have less money to lend. Business is apparently finding it hard to get credit at the moment, which is holding back the recovery. The new rules could make this worse – which may be one good reason why they are being phased in slowly. But that doesn’t change the fact that this will impose higher costs of borrowing on business in the future.

Weighing the uncertain benefits of the Basel deal (which may even be zero or negative) against the real costs, this starts to look like a rather unexciting deal, perhaps even a bad one – and definitely not the salvation Peston and others want it to be.

The fact is that we have tried this type of crude “risk-based capital” regulation before. Each time it has failed. Is there an alternative? Well, how about trying a radical new approach to regulation that, as we explain in The Road From Ruin, rather than treating the banks as naughty children who need to be disciplined, actually helps them to understand and manage risk better? The financial crisis was bad for many bank executives and a catastrophe for many bank shareholders. The financial sector has as much interest in preventing the next crisis as the regulators: let’s come up with an approach to regulation that recognises this.

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