Monday, September 13, 2010

Basel III is out... who cares?

So the new rules for banks out of the Basel committee are out this morning. There is a flurry of articles in the press. I will focus on 2 in the FT.

First an overview of the new rules here.

Global banking regulators on Sunday sealed a deal to effectively triple the size of the capital reserves that the world’s banks must hold against losses, in one of the most important reforms to emerge from the financial crisis.

And an early criticism here.

A recent paper by Samuel Hanson, Anil Kashyap and Jeremy Stein underlines a crucial point: to be any use, the regulatory minimum capital ratio in good times must substantially exceed the market-imposed standard in bad times: “Thus if the market-based standard for equity-to-assets in bad times is 8 per cent, and we want banks to be able to absorb losses on the order of, say, 4 per cent without pressure to shrink, then the regulatory minimum for equity-to-assets in good times would have to be at least 12 per cent.” The authors add that 4 per cent is a conservative estimate – cumulative credit losses at US banks between 2007 and 2010 were roughly 7 per cent of assets.

I do believe these are positive steps since they will make banks more resilient to shocks. Capital cushions are essentially tripled. Also note that with loss rates around 7% a 7% capital base should suffice. The banking system will not be bankrupt, as it is today, at least from a accounting standpoint. See here for a study on monetary levels in the face of losses. Basically money supply would NOT sharply contract at the current level of losses. That is a good thing.

However I am usually not one to wallow in criticism for the sake of criticism or pessimism but the whole effort while worthwhile and positive does ultimately fail to address one root cause of the modern credit crisis: securitization and the fact that debt levels are not REALLY regulated any more. The Basel type regulation focuses on accounting numbers relating to the banks: assets on their balance sheet vs capital cushions. But CDOs are designed to move assets off balance sheets. The banks get cash and most of the AAA assets move away. The more toxic tranches are hidden in special purpose vehicles and the regulator is none the wiser. So the real level of debt is really not captured on the balance sheet of the banking system. It has moved to the shadow banking system. In other words, Basel III makes banks more resilient in the face of a crisis but does not address the likeliness of the crisis.

In conclusion I suspect that is the way they want it. After all, as far as I can tell, Basel is a set of self-imposed rules by the banking system and their regulators and they are primarily concerned with their own survival, not the well being of the economy from a monetary standpoint. It should be no surprise that they avoid the larger question of systemic stability by monetary self-regulation. Beware of the invisible hand, it may be robbing your back pocket!.

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