The search for Basel III loopholes begins

By Felix Salmon
April 12, 2010
big-picture story is clear: banks around the world are ganging up to try to weaken and/or delay Basel III's implementation.

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Patrick Jenkins of the FT has two great articles today following the maneuvering around Basel III. The big-picture story is clear: banks around the world are ganging up to try to weaken and/or delay Basel III’s implementation.

Most of the arguments could be made only by banks who have been drinking their own kool-aid for so long that they no longer have any idea what sounds ridiculous and what doesn’t. I hope that the world’s central bankers aren’t going to be swayed by stuff like this:

Bankers say that by Friday’s deadline the committee will be inundated with protests, complaining that the the proposals – designed to insulate the industry from another financial crisis – could backfire, cutting bank profits to unsustainably low levels…

Banks’ return on equity levels would be cut by at least a half, according to many bankers and analysts, to as little as 5 per cent. They argue that the industry would find it impossible to attract new investors, in competition with more profitable sectors.

Actually, banks are entirely sustainable so long as their profits are positive. A return on equity of 5% is still going to be significantly higher than the developed world’s GDP growth rate, so I see nothing unsustainable there. Might it mean that banks couldn’t grow as fast as they want to? Yes, but that’s a feature, not a bug. And so long as banks are profitable, they don’t need to attract new investors. In fact, if more profitable sectors get more investment and banks get less, that’s surely a good thing from the point of view of global productivity. The banking sector is far too big, as a percentage of GDP, and needs to shrink in comparison to sectors which create much more real value.

This part scares me more, though:

The danger, says the Institute for International Finance, the global bank lobby group, is that if Basel takes too draconian a line, hopes for a co-ordinated global approach to include the US could crumble.

The question of the US is absolutely the elephant in the room. America, remember, hasn’t even adopted Basel II yet, and Basel III is a revision to Basel II. So it’s crucial that the US take a lead on this. But I’ve heard very little in the way of noises from senior US officials about how aggressive they’re being in terms of pushing through Basel III. Instead, I’ve heard a lot of stuff in the passive voice, and I fear that the US simply isn’t investing sufficient political capital in Basel III to make sure that it will get implemented on time in this country.

So other countries’ concerns seem to be taking center stage. The French, for instance, don’t want their banks to be fully responsible for the capital requirements of subsidiaries, when other shareholders hold a large minority stake. But of course they should be, because when push comes to shove the majority shareholder is ultimately going to be liable for losses at the subsidiary — just as Citigroup and others were ultimately responsible for their nominally off-balance-sheet vehicles.

And then there’s the vexed question of turning losses into capital:

The planned ban on most deferred tax assets – counting prior-year losses as capital on account of its potential boost to after-tax earnings – is particularly sensitive in Tokyo, where in some years they have accounted for the majority of bank capital, according to estimates.

But never mind, Goldman Sachs is here!

The more entrepreneurial investment banks – traditionally the likes of Goldman Sachs, JPMorgan and Deutsche Bank in this kind of area – have spent recent weeks touting new product ideas to banks that will be hit by the new rules.

The initiatives are focused in particular on ways in which deferred tax assets – to be outlawed as capital under current Basel thinking – can be turned into cash or an equivalent that would be valid for capital purposes.

Bankers say the assets could be sold at a discount of 20-30 per cent, either via actual sales or using derivative instruments, to non-bank buyers.

In principle, this could work. If a bank can turn its deferred tax assets into hard cash, then that’s great, it can count that hard cash as capital. But the whole point about deferred tax assets is that only the entity which suffered the loss in the first place can benefit from them: they’re not tradable or fungible, and if you never make a profit, they’re worthless. (Just ask General Motors.) So who would buy these things, and how? If they create an obligation of the bank to pay to investors the first X dollars in future profits, I can imagine all manner of accounting shenanigans.

I think that Jenkins is absolutely right to be suspicious of this kind of financial innovation:

Many bankers will support the initiatives as good creative thinking. But critics will see them as the latest evidence that banks have not learned their lesson from the crisis and will always focus on arbitraging the system for a profit, however tough the rules.

The whole point of Basel III is that it’s meant to be robust and Roman; these new products are a way of turning it complex and Greek again before it’s even been finalized. Which is depressing.

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