Wednesday, December 7, 2011

WSJ: Regulators create systemic risk

In an editorial on the Basel capital requirements, the Wall Street Journal observed that through these requirements regulators are creating systemic risk.

Regular readers know that the global financial regulators are a source of systemic risk because of their monopoly on all the useful, relevant information for assess the risk of a bank.

The WSJ identifies yet another way that the global financial regulators create instability.

In this case, the regulators do it by the risk weightings they put on different asset types that banks hold.  These risk weightings encourage banks to have similar portfolios.  As a result, a problem with one asset type is likely to permeate the entire banking system.

The Basel capital requirements themselves are the product of banking regulators in the 1980s attempting to help banks generate a higher Return on Equity so that the banks could attract capital. [I know as I worked on Basel I.]

The idea of risk weights was developed to allow banks to take on more leverage.

The idea of a risk-free asset that would have a zero risk weight has always been fundamentally flawed.  The only asset that a bank holds that fits this criteria is cash in its vaults.  All the other assets have a component of risk:  including credit, interest rate and liquidity.

It is well known that zero risk weight sovereign debt is definitely not risk free.  For example, a large bank in the US managed to lose over half of its book value from a position in long term US Treasuries.

Standard & Poor's Monday night put nearly every country in the euro zone on notice for a possible credit downgrade ... European officials denounced the announcement as counterproductive and somehow politically motivated, but the rating agencies are merely catching up to the reality that sovereign debt isn't a risk-free asset.  
This same realization may even be dawning at last on the international banking regulators in Basel, Switzerland. Business Week reports that the authors of the Basel standards, which set capital and liquidity requirements for large international banks, are reconsidering rules that all but require banks to hold large amounts of sovereign debt. 
Unfortunately, the rules under review concern only the new liquidity buffers that banks will need to hold under the forthcoming Basel III standards. Under this new requirement, banks are supposed to have a 30-day supply of funds available in case lending markets seize up as they did in the fall of 2008, and 60% of that supply is supposed to be in high-quality, highly liquid assets, such as, believe it or not, government bonds....
Under Basel's risk-weightings, government debt of your home country is assigned a zero risk under both the old rules and the new. 
The rationale is that a government can always tax more or print more money to pay off its debts, at least nominally. So a country that issues debt in its own currency should in theory never be forced into actual default, even if it has to resort to inflationary money printing to avoid it. 
On this, the Basel gnomes have a point, even if it's taken everyone too long to realize that this option wasn't open to the likes of Greece and Italy. 
But even when correctly applied, those rules create systemic risk by nudging large banks toward holding similar assets. This reduces diversity in the system, increasing the odds that if one bank is in trouble, all or most of them will also be in trouble. 
A normal market has a balance of buyers and sellers, longs and shorts, bulls and bears. But risk-weightings put a thumb on the scale. 
Recall that the Basel rules also assigned a very low risk-weighting to triple-A-rated mortgage-backed securities, which helps explain why sleepy banks in Dusseldorf loaded up on the stuff during the housing bubble and lost billions during the panic. 
And now here we are doing it again with sovereign debt. 
In a paper commissioned by the European Parliament in 2010, former Commerzbank Chairman Achim Kassow notes dryly that "The regulatory incentive which results from the 0% risk weight is apparent: banks in Member States are effectively encouraged to place their most liquid assets into the worst possible government debt, maximizing the yield with a regulatory capital requirement of zero." 
It's encouraging that the Basel rule makers are considering even a limited climb-down from pushing banks into government bonds, but the whole policy needs revision.

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