The biggest weakness of Basel III

September 15, 2010
Economist and the second at The American Scene, Noah Millman does an excellent job of explaining the biggest weakness with Basel III. Which also happens to be the biggest weakness with Basel II.

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I’m unapologetically happy and optimistic about the outcome of the Basel III process, and I haven’t been impressed by most of its critics — until now. In two posts, the first at the Economist and the second at The American Scene, Noah Millman does an excellent job of explaining the biggest weakness with Basel III. Which also happens to be the biggest weakness with Basel II.

The problem is that while Basel II was a bold experiment which took a decade to put together and which even then never really got implemented, Basel III was much more of a rush job, and therefore could not be a soup-to-nuts reimagining of what a global macroprudential regulatory regime should look like. Even if that were a good idea.

Instead, Basel III is essentially a bold new layer built over the old Basel II architecture, in much the same way that early versions of Windows were layered on top of DOS. And just as early versions of Windows shared some of the weaknesses of DOS, do has Basel III inherited some of the problems of Basel II.

The main one is the whole concept of risk weighting: the idea that some assets are riskier than others, and that banks should hold more capital against risky assets (unsecured loans to people with a 550 credit rating, say) than they do against much safer assets, like loans to the US government.

That makes a certain amount of sense, but there are two main problems with it. For one thing, it’s backwards-looking: it reckons that the securities which have been risky in the past are the same as the securities which will be risky in the future. That obviously isn’t true. And secondly, it’s easy to game. Here’s Millman:

The consequence of this Basel II reform was to discourage banks from lending to risky enterprises, and to encourage the accumulation of apparently risk-free assets. This was a primary contributor to the structured finance craze, as securitisation was a way to “manufacture” apparently risk-free assets out of risky pools. What brought banks like Citigroup and Bank of America to their knees wasn’t direct exposure to sub-prime loans, but exposure to triple-A-rated debt backed by pools of such loans, debt which turned out not to be risk-free at all.

Since it did not change this risk-weighting, Basel III effectively doubles down on Basel II. Banks will need to hold more common equity than ever—against their risk-weighted assets. That massively increases the incentive to find low-risk-weight assets with some return, since these assets can be leveraged much more highly than risky assets. Unless I’ve missed something, lending to AA-rated sovereigns still carries a risk-weight of zero. So one result of Basel III could be to encourage banks to increase their lending to sovereigns at the margins of zero-risk-weight status. If that happens, anyone want to guess where the next crisis will crop up?

This is all absolutely true, but at the same time a sovereign default is always going to cause a banking crisis, no matter what kind of capital-adequacy rules are in place. Central banks can’t protect banks from sovereign default, and neither can banks themselves. If you’re a bank and the country you’re based in goes bust, then you’re going to go bust too.

But Millman’s broader point is spot-on:

Since taking any additional measurable risk is now stigmatized, the game becomes how to increase returns without increasing measurable risk…

Developments in banking regulation in the last decade, meanwhile, have turbocharged this process, and I’m increasingly convinced contributed mightily to the financial crisis. At the heart of the financial crisis, after all, was banks investing in highly-rated debt backed by lousy mortgages. But why did they hold so much of this debt? In part because they could plausibly argue that it was risk-free or nearly risk-free… If the exposure was classified as market risk rather than credit risk, the Basel II framework was based on Value-at-Risk, which showed very low volatility.

The big-picture point to take home is: the regulatory framework recommended by Basel II assumes that banks are in the best position to measure their own risks, and that a regulatory framework that aligns regulatory capital requirements with the risk being taken is to be desired. In other words, the regulatory framework was pushing banks hard in the direction they were already going: towards avoiding measurable risks and hence (since you still have to make money) into risks you can’t easily measure (or don’t know exist).

As Joe Nocera explains, the whole Value-at-Risk structure gives banks every incentive to push risk into the tails. And because tail risk can be ignored, banks then go on to embrace other mechanisms — like the Gaussian Copula Function — which essentially fatten the tails, stuffing them with ever more risk. There’s not much in Basel III which directly addresses this problem.

And there’s another weakness in Basel III, too. I was at a Manhattan Institute event this evening, at which Paul Singer of Elliott Associates stood up and declared that the big systemic losses which resulted from the bankruptcy of Lehman Brothers were not actually a function of any kind of monster hole in Lehman’s balance sheet. Instead, after Lehman declared bankruptcy, its enormous derivatives book needed to be unwound very quickly, and it was that unwind which caused something between $50 billion and $75 billion of losses, precipitating the worst months of the crisis.

Singer wasn’t saying that the derivatives book caused Lehman’s collapse — far from it. The book was actually pretty kosher. The cause of Lehman’s collapse was liquidity problems, and Basel III does a pretty good job tightening up the rules on bank liquidity. But if a bank with a big derivatives book does end up declaring bankruptcy, the effects can still be catastrophic. Again, that’s not something that can readily be addressed in the Basel III architecture — it requires instead a lot of detailed tinkering with bankruptcy laws. Still, the tail risk remains.

Ultimately, Basel III does a good job of reducing foreseeable risks, and, like any ex ante regulatory structure, it does a bad job of reducing unforeseeable risks. The problem is that as a result, banks are incentivized to load up on the kind of securities which can blow up in unforeseeable ways. I’m not sure that’s something that the Basel Committee could ever really address, but it’s worth remembering, all the same.


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