Basel Committee seeks to limit bank-to-bank exposure

In another classic example of the substitution of complex rules and regulatory oversight for the combination of transparency and market discipline, the Basel Committee is looking at how to limit bank-to-bank exposures so as to eliminate the risk of financial contagion.

The Basel Committee is effectively trying to do through regulation what market discipline would do more efficiently if banks were required to provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.

Regular readers know that our financial system is based on the FDR Framework which combines the philosophy of disclosure with the principle of caveat emptor (buyer beware).  It is the principle of caveat emptor that makes each bank responsible for all losses on their exposures, including to other banks.

With the responsibility for losses comes the incentive to limit exposures to what the bank can afford to lose.

With transparency, banks look at their exposures to other banks not just as an exposure to another bank, but as an exposure to that bank's exposures.  It is these exposures that drive losses at both banks and therefore banks set their exposures to each other based on the risk of the other bank.

When the level of inter-bank exposure is based on transparency of each bank's risks, the global financial system both minimizes financial contagion and maximizes inter-bank exposures needed for supporting the real economy.

As reported by Reuters,

Global regulators have proposed tougher rules from 2019 to stop big banks from building a level of risk on their books that would make them vulnerable if a major customer goes bust. 

In an attempt to gain transparency on bank assets and facilitate speedy action from regulators in the event of a crisis, the global Basel Committee on Banking Supervision is proposing much tougher rules on banks' exposure to other banks. 

The aim is also to reassure markets that when a bank is in trouble, other banks' exposure to it would be relatively limited to avoid the type of contagion seen during the 2008/09 financial crisis.

Why attempt to gain transparency on bank assets and reassure markets through complex regulation when simply requiring banks to provide ultra transparency permanently solves the problem?

Big losses at some banks on asset-backed securities in 2008 prompted investors to withdraw funds from a wide range of lenders, exacerbating the market turmoil....

Investors withdrew funds because banks are 'black boxes' and there was and still is no way to assess each individual bank's solvency or risk.

Again, a problem solved by having the banks provide ultra transparency.

Basel is now proposing to impose a stricter exposure limit on big banks and a requirement for more detailed reporting on exposures. 

"This is to ensure that the large-exposures standard is effective and consistent for internationally active banks," a committee statement said. 

"On this basis, breaches of the limit should be exceptional events, should be communicated immediately to the supervisor and should, normally, be rapidly rectified."

Basel said that the very biggest banks would only be allowed to conduct business with another bank of similar size up to the equivalent of 10-15 percent of its core capital, well below the 25 percent limit recommended at present....

The Basel Committee is proposing substituting regulations and regulatory oversight for transparency and market discipline.

Exposure limits by their very nature are fundamentally flawed.  For example, is the 10-15% of core capital exposure limit based on gross or net exposures?  I ask because it is often the case that a net exposure becomes a gross exposure when the bank on the other side of the transaction fails.

"The knock-on effect is another dampener on the flow of capital around the system. It's a bit more grit in the machine," said Richard Barfield, of accountant and consultancy PwC. 

"What is coming into focus is the whole balance between the supervisory appetite for risk and the need to have a financial system that can support international business activity and commerce efficiently."

It is not a supervisory appetite for risk, but for additional regulation.  When the system fails next (and it already has in Greece, Cyprus,...), the regulators want to be in a position to say it was not their fault, just look at all the regulations.

The financial crisis highlighted the simple fact that a financial system that is dependent on the combination of complex regulations and regulatory supervision is prone to failure.  This is not surprising as the system has a single point of failure: the regulators.

Fortunately, our financial system is designed not to have a single point of failure and to be much more robust and resistant to failure.  Our financial system achieves this through transparency and caveat emptor.  When everyone is responsible for their losses, our financial system is much more robust and resistant to failure.

Where our financial system failed was in the areas it was dependent on the regulators.