The key to the future of finance is now emerging

September 15, 2010

This week I lovingly disparaged those members of the media who spent much time covering the new and improved bank regulatory scheme known as “Basel III.” As someone who was quizzed by my father about the original 1988 Basel accord, I don’t give a toasted sausage about Basel III and said so recently:

Basel III is entirely irrelevant to the economic situation and even to the banks. Through things like minimum capital levels, the Basel II rules provided the illusion of intelligent design in the regulation of banking and finance. In fact, Basel II made the subprime crisis possible and the subsequent bailout inevitable [by enabling off-balance sheet finance and OTC derivatives].

Part of the reason for my undisguised contempt for the Basel III process comes from caution regarding the benefits of regulating markets. In the 1930s, the U.S. government took responsibility for the soundness of banks and markets.  Since then we’ve had nothing but an accumulation of public sector debt and growing market volatility, begging the question as to whether the Treasury’s legal monopoly on regulating a market filled with fiat paper dollars is really a public good.

But a large portion of my criticism for Basel III and the entire Basel framework is even more basic, namely the notion that any form of a priori regulation, public or private, can prevent people from doing stupid things. Neither the failure of Lehman Brothers nor Bear Stearns were caused by a lack of capital. “When a bank goes bad, it doesn’t make much difference how much capital it has,” former Fed Chairman Paul Volcker said recently.

To me, the even more offensive thing about Basel II/III is the financial and economic assumptions which underlie the framework. This week in The Institutional Risk Analyst, we republished the written Testimony of David Colander as submitted to the Congress of the United States, House Science and Technology Committee on July 20, 2010. His views on what is right and wrong with economists and the world of economic research are very much at the heart of the problems with Basel III, at least as sold by regulators to their respective voters in the G-20 nations.

The key premise of Basel III is that the use of minimum capital guidelines and other strictures will somehow enable regulators to prevent a crises before it occurs. The only trouble is that regulators have no objective measures for compliance with Basel II/III, much less predicting market breaks. There is also the larger issue of the conflict between the Fed’s monetary policy role and its job as regulator.

Fed Chairman Ben Bernanke told Congress recently that the Fed and other regulators must rely on the disparate internal systems of the banks to monitor compliance with regulations. But this assumes that bank managers themselves understand the risks they face. Do you think JPMorgan CEO Jamie Dimon knew last week that his bank had a serious problem with its website? Risk is no more predictable than life and no more amenable to statistical forecasts than the weather.

As in past decades and crises right through to 2008, the regulators will be the last to know about a problem. The fact that the Fed and other agencies have no objective means of measuring compliance with Basel III and other regulatory norms is but your first hint of trouble. Add to that basic problem the use of suspect methodologies to measure risk and thus prescribe minimum capital levels. This is the next indication of serious issues with the regulatory status quo which is now reaffirmed in Basel III.  Then add to that the lack of a unified set of accounting rules and the de facto regime of “national treatment” that prevails within the G-20 nations, and it seems reasonable to ask whether Basel III is really worth all of the trouble and bother.

What is more important than Basel III for customers and creditors of and investors in banks? The accounting rules changes on off-balance sheet (OBS) vehicles and the fair-value crusade being led by the Financial Accounting Standards Board are top of the list for our clients.

The EU and SEC/FDIC rules processes on securitization are #2 on the important list. While everyone focuses on Basel III, the key to the future of finance is emerging now with the implementation by the EU of something called “Article 122a” regarding asset backed securities (ABS).

Article 122a is an amendment to the European Capital Requirements Directive. Specifically, it requires European credit institutions that invest in structured finance securities to know what they own. It lays out explicit penalties if a European credit institution does not obtain sufficient data regarding an ABS to satisfy regulators that the buyer fully understands the security.

Would that American regulators dared to propose anything remotely like Article 122a to bring order to the U.S. market for structured notes and derivative securities. Indeed, the divergence in goals and objectives between the EU and the U.S. over bank regulation could grow after the November election, when the Republicans are expected to win big. My prediction is that if the Republicans prevail at the polls, the U.S. may go its own way on Basel III. Stay tuned.

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