Felix Salmon

The quiet victory of Basel III

Felix Salmon
Sep 14, 2010 04:46 UTC

With a full news cycle now having been and gone since the Basel III accord was announced, a few things have come into more focus.

First, there will always be cynics and nay-sayers. Some of them are serious analysts who wanted a higher capital standard. But most are based on some variation on a simple, defeatist theme: “this doesn’t guarantee that there won’t be another crisis, and banks are still able to engage in dangerous behavior, therefore this is useless”. All I can say is that I’m very glad that the world’s central bankers didn’t feel that way and instead worked long and hard to try to put together a new set of standards which really will reduce systemic risk and strengthen the international banking system.

Of course, banking crises are always possible. But anything which reduces their likelihood is a good thing and Basel III reduces the likelihood of a banking crisis much more than all of Dodd-Frank put together.

Which brings me to Robert Peston, who’s upset at the media for not covering Basel more thoroughly. I’m sympathetic: I’m one of the few financial commentators in the mainstream media who, like Peston, has been banging on about this for a while, returning to the subject on a regular basis. And certainly, compared to Dodd-Frank, Basel III has received almost no press at all. But I part ways with Peston here:

There’s been little populist debate about how much capital and liquidity banks ought to hold for our own welfare. We’ve been presented with a fait accompli.

And most would argue that the media hasn’t exactly done a brilliant job in shining a light even on that fait accompli.

You might also ask where our [elected representatives] have been while unelected central bankers and regulators have trampled on territory that they would surely regard as their own, viz the fundamental laws that affect how [our] banks conduct their affairs.

So if you felt there had been something of a democratic failure here, you might have a point.

The way I see it, the Basel committees did a masterful job of depoliticizing the process as much as possible. The agreement is a win for Treasury, but Treasury was clever in not presenting it as such, because a large number of Republicans will automatically oppose anything that Treasury thinks is a good idea. The functionaries in Basel were generally mid-level central bankers, staying out of the spotlight as much as possible and putting together the best deal they could come up with. If politicians and the media had got involved, that might have made the process more democratic, but it would also have made it much more chaotic and quite possibly would have derailed any chance of an agreement at all.

The fact is that democracy simply isn’t the best possible way to construct a coherent regulatory regime for cross-border financial institutions. And the general public has every right not to feel the need to understand the difference between core Tier 1 and Tier 2 capital, or the finer points of how bank assets should be risk-weighted. This is something which central bankers, as a rule, know how to do — and the great news about Basel III was that they were given the freedom to go ahead and do it, while the power of the banking lobby was temporarily muted and in a period when anybody espousing a laissez-faire approach would automatically get laughed out of the room.

The main thing to take away from the Basel III announcement is that banks now need a lot more equity then they ever did in the past. It’s a little bit of a rhetorical stretch to say that the requirement for core equity has gone up from 2 percent to 7 percent, but it’s narrowly true all the same, even if the 2 percent requirement was never a central part of Basel 2 in anything like the way in which the 7 percent is the very heart of Basel III. And although the 7 percent requirement isn’t formally in effect, you can be sure that every bank in the world now feels the need to meet it. In fact, Credit Suisse said in a research note today that 8 percent is now the market standard for banks to be considered adequately capitalized.

Under previous administrations, financial regulations were quietly loosened, with disastrous results: think of the way that the SEC allowed almost unlimited leverage at investment banks in 2004, for instance. This time around, financial regulations are being quietly tightened. That’s a good thing and should definitely count as a signal achievement of the Obama administration. Even if the president himself isn’t going to make a major television address to trumpet it.


We cannot just be negative.

There is no way to zero risk in banking, this is for sure. Basel iii is not perfect, but it is better than Basel ii.

The framework improves consistency and establishes risk management principles that are unique.

Yes, we will have another crisis in the future, this is also for sure. It is simple: Passing laws against robbery and murder has not stopped people from robbing and murdering.

To ban or not to ban taking risks? More strict banking rules can destroy the economy. Banks will not be willing to lend. What is next? Unemployment, bankruptcies, no mortgages…

Banks are (and must be) in the business of taking risks. Sometimes governments force banks to lend to at-risk borrowers, and decisions are based on government intervention, not risk management. Is there a framework against that? Can we blame Basel iii?

We can increase the likelihood that banks can absorb losses under certain circumstances. This is all we can do.

George Lekatis

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Adventures in information design, WSJ edition

Felix Salmon
Sep 13, 2010 22:28 UTC

Last week, Justin Lahart presented an interesting thesis in the WSJ:

For American business, it has become a two-track economy.

While global players like industrial conglomerate 3M Co. and burger giant McDonald’s Corp. are getting ever-bigger boosts from their operations in fast-growing economies like China and Brazil, companies dependent on the U.S. market are hemmed in by recession-scarred consumers who are hesitant to spend.

The accompanying chart was one of the most incomprehensible things I’ve ever seen on newsprint:


I doubt that one reader in 20 actually understood, on looking at this chart, the information it was ostensibly trying to get across.

There are three axes here, and two colors, and all manner of confusion. It took me a while to work it out, but I got there in the end: the height of the bars represents a healthy year-on-year increase in projected revenues. They increase in volume the further that number is from zero, so that the smallest bars aren’t the companies with falling revenues, but rather the companies with flat revenues. That’s silly. And because of the 3D effect, the biggest bars have much more volume than the smallest ones, as though the product of the two variables is somehow important. (It isn’t.)

The amount of color in a bar represents the proportion of those revenues that come from outside the US. The main axis we see when we look at the chart — the one marked with a bold black line — doesn’t actually represent anything at all. Oh, and the chart claims to be “an analysis of the 30 companies in the Dow”, but it only features ten stocks.

The weird thing is that Lahart’s thesis would come out loud and clear from a simple scatter chart. Put the change in revenue on one axis, put the percentage of revenue coming from overseas on the other axis, and look for two clusters: one at the top right, with the companies active in fast-growing countries, and one at the bottom left, with the companies hemmed in by recession-scarred consumers.

It took me a while, but I eventually got my hands on the data that Lahart was using. So I decided to plot that scatter chart, to see what it looked like:


I’m not a professional designer, and this could certainly be a lot prettier, especially if I could get my fonts to work and if I remembered to get rid of those silly decimal places on the y-axis. Still, the message of this chart is much clearer, I think, than that of the one in the WSJ. It does show a clear correlation between revenue growth and foreign sales, but I can’t see much of a case that American businesses have diverged onto one of two tracks.

All of my numbers are exactly the same as the ones that the WSJ used — even the 0% of foreign sales for Verizon, which resulted in a correction. (Verizon claims it gets some revenue abroad, although it’s less than 10%.) So I’m puzzled why the WSJ didn’t include Caterpillar as one of the “five companies with largest share of overseas revenue”: it’s up there in fourth place, with 67%, higher than both Hewlett-Packard and McDonald’s.

So, what really happened here? Did Lahart know that a clear chart would somewhat undercut his headline talking about a “two-track economy”, and therefore contrive something messier instead? Or was there just an overenthusiastic new kid at the WSJ who hasn’t read his Tufte? Either way, it would be great to see a stronger emphasis on clear information design at the WSJ. Financial publications have an especial responsibility to do this kind of thing well, given the highly-quantitative nature of what they’re writing about. The NYT has fantastic information designers; let’s hope the WSJ tries hard to compete on that front.

Update: Andrew Burton points out there’s actually a Wall Street Journal Guide to Information Graphics, by Dona Wong, available on Amazon in hardback for $19.77. I wonder what she would have to say about the WSJ’s chart.


Of course, this would be MUCH better if they simply showed the growth rate of overseas revenues and the growth rate of US revenues.

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The politics of pay on Wall Street

Felix Salmon
Sep 13, 2010 15:30 UTC

London fund manager Barry Olliff seems to be on the same page as Silicon Valley venture capitalist Ben Horowitz when it comes to paying employees.

Here’s Olliff:

Selfishness creates an attitude of negotiation at the point of salary, bonus and option notification. At City of London we do not negotiate any aspect of remuneration…

If we are genuine in wishing to create a team culture then there is a need to treat employees as a team. This in effect means that we do not pit them one against another. Rather we attempt to instil in them that the competition is outside the firm, which actually is where it is.

The net result of the above is that there is little intrigue at the point of salary and general compensation disclosures. Staff accept that the way it is, is the way it is. If they do not like it they can leave which sometimes happens within a year of joining.

And here’s Horowitz:

A CEO creates politics by encouraging and sometimes incenting political behavior—often accidentally. For a very simple example, let’s consider executive compensation. As CEO, senior employees will come to you from time to time and ask for an increase in compensation. They may suggest that you are paying them far less than their current market value. They may even have a competitive offer in hand. Faced with this confrontation, if the request is reasonable, you might investigate the situation. You might even give the employee a raise. This may sound innocent, but you have just created a strong incentive for political behavior.

This kind of thinking runs counter to what one finds at Goldman Sachs, where there’s a real emphasis on rewarding — and punishing — individuals:

On Wall Street, becoming a partner at Goldman Sachs is considered the equivalent of winning the lottery.

This fall, in a secretive process, some 100 executives will be chosen to receive this golden ticket, bestowing rich pay packages and an inside track to the top jobs at the company.

What few outside Goldman know is that this ticket can also be taken away.

As many as 60 Goldman executives could be stripped of their partnerships this year to make way for new blood, people with firsthand knowledge of the process say. Inside the firm, the process is known as “de-partnering.”

The two philosophies are not completely incompatible. Great team members can and should be rewarded with raises and promotions, even when such things aren’t the result of negotiations, and Goldman partners don’t negotiate their position in any real sense: they’re quietly vetted, and then called in to the CEO’s office to be told the good news. What’s more, Goldman does try to reward people who build great teams and who work for the greater glory of the franchise instead of trying to burnish their personal credentials.

But all the same, Goldman is a company of 35,000 employees with just 375 partners — and Goldman president Jon Winkelried once said that making partner was viewed as the real beginning of a career at the firm. Given that one in four of Goldman’s existing partners faces the humiliation of de-partnering next month, it’s reasonable to assume that Goldman employees, both before and after they make partner, are competing against their colleagues just as much if not more than they’re competing against their actual competitors.

I do think it’s possible to create a bank built around teams which can last for years and which aren’t torn apart by an up-or-out culture. But such banks tend to be small, and it’s definitely seems as though it’s easier to build those structures if, like Olliff, you’re on the buy side rather than the sell side. Any idea as to why that should be the case?

Should we worry about the Basel delay?

Felix Salmon
Sep 13, 2010 13:48 UTC

Two of the smartest people I’ve met are coming out this morning with an unexpected (to me, at least) criticism of the Basel III rules.

Mohamed El-Erian:

“The phasing-in period for the new capital requirements is surprisingly long, which will add to the skepticism about the robustness of the bank capital enhancement efforts.”

Joe Stiglitz:

“While it’s understandable, given the weaknesses and the failings of the banking system, that one would want to be slow in introducing these increased capital requirements, delay is exposing the public to continued risk. Given the high levels of payouts in bonuses and dividends, it seems a little unconscionable to continue putting the public at risk with an argument that they cannot more rapidly increase their own capital.”

I haven’t been particularly worried about the timetable up until now, mainly because I haven’t seen much evidence that any systemically-important banks are going to take advantage of the long phase-in period to get away with having capital levels lower than the eventual minimum.

Of course, systemically-important banks are going to have an extra too-big-to-fail capital requirement slapped onto them, over and above the minimum requirements laid out yesterday. So it’s just as well that all of them are currently in compliance with the vision that the BIS technocrats have for smaller banks around the world. (Deutsche Bank might not be there today, but it will be once it’s done raising $12 billion in new capital.)

But the big bonuses that Stiglitz is worried about are overwhelmingly paid out by banks which would be compliant with these new Basel III rules even if they were implemented tomorrow. And once a bank is compliant, the market will punish it severely if it slides back during the phase-in period.

It seems to me that when it comes to the big players in the interbank markets, and any bank with a decent-sized capital markets division, the Basel III standards are de facto in place right now; the only exceptions are banks which have already been nationalized. Or am I missing something here?


The basel framework is simply a HUGE step forward when compared with the status quo. The added flexibility will allow national regulartors to implement countercyclical policies.

The best part is that because of the 2.5% cushion CEO’s won’t be able to be even near the mnimums because to do so would make it impossible to raise new equity or preffered equity.

The one “problem” is that goverments are sort of expecting banks to use the phase in period to slowly build up capital through earnings retention. That will absolutely NOT HAPPEN. Banks were shrinking their balance sheets before these requirements were released… they will do so with increased urgency now.

You will see a race to get capital ratios up above maximum ranges… some banks are already there.

The easiest way to increase your capital ratio is run a report on your loan portfolio and then simply not renew your least profitable customers.

I’m sorry Wal-mart… we won’t be re-upping your $100,000,000 line of credit anymore because we aren’t interested in lending a penny at LIBOR -50bps. Ya, I know you’re a big account… it’s just that your business is marginally profitable and by dropping the 10% of customers who are the least profitable we increase our capital ratios by a full percentage point like the goverment wants.

That is absolutely playing out right now. Borrowers who were use to rate shopping are getting the cold sholder. Depositors who are threaten to pull their deposits because of paultry rates are being told “I’m very sorry to lose your business Mrs. Smith”… (but that is EXACTLY what I want because I don’t need your deposits because I’m not trying to grow my loan book.)

Over all I’m thrilled with the Basel framework.

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Felix Salmon
Sep 13, 2010 07:36 UTC

Even in New York City, $250,000 is rich — WaPo

Woman doors & kills cyclist, then tries to leave for a baby shower. NYPost commenters pile on, blaming… the cyclist — NYP

“Fortuitously, there exists one location that would be ideal for the ‘Ground Zero mosque.’ That would be Ground Zero.” — TNY

Sue Craig, in her first NYT story, recapitulates a story she wrote, better, 4 years ago — NYT, Times

“The value of a house is the capitalised value of the stream of housing consumption provided by it over its lifetime. So it depends on the capitalisation rate used. You can’t ignore the level of interest rates in thinking about these things.” — Dsquared

Even after Lehman collapsed and Einhorn’s Allied book was published, Allied was paying Sitrick to discredit him — Boyd

Forbes Jumps the Shark — MoJo

The Death Of The RSS Reader — PaidContent

“The HP board can now lay claim, officially, to the title of the Most Inept Board in America” — NYT

High income improves evaluation of life but not emotional well-being — PNAS

If the Fed wants to do a $300bn helicopter-drop onto Treasury, all it needs to do is mark its gold to market — Alea

“It’s the best first day of school they’ve ever had” — SFGate

Research subjects treat computers like other people — WSJ

Think your seat in coach is cramped? Take a look at the SkyRider — USA Today

March 2007 was not Austan Goolsbee’s finest hour. “The mortgage market has become more perfect, not more irresponsible” — NYT

How to get ahead at Citi, if you’re a woman: “one good pump” on the handshake, ladies — Dealbreaker


“Flabbergasted” was the perfect word for the Mother Jones article the Forbes cover story. Holy crap was what I said out loud though…

Obviously you are not writing a smack down?

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How the WSJ magazine fails its readers

Felix Salmon
Sep 13, 2010 00:30 UTC

Lucas Conley’s piece on Ugg for the WSJ’s magazine is a perfect example of why the WSJ shouldn’t have a glossy, fashion-friendly magazine.

Conley does a reasonably good job of covering the way in which Deckers Outdoor Corporation, the American company which owns the Ugg trademark, has become a highly-aggressive trademark troll, and in the process has helped to decimate a small but longstanding Australian industry. But having found that story, he buries it, and ends up capitulating to all the evil impulses of the fashion industry.

If you read closely, you’ll find Conley explaining how, despite the fact that “uggs have been a cottage industry in Australia for decades”, Deckers became extremely aggressive when it comes to those small local companies, slapping them with cease-and-desist orders and in general trying as hard as they could to use trademark law to shut down anybody who might be considered a competitor. It won in the US against Koolaburra, a US firm importing sheepskin boots and selling them under the name “ug”, although it lost in Australia against Uggs-n-Rugs, a 32-year-old sheepskin outfitter. But the big picture is clear:

While Deckers may have lost the Australian trademark battle, the company is winning the war. Today, Deckers owns “ugg” trademarks in over 100 countries, protecting them with high-tech anti-counterfeiting tools and a sophisticated network of lawyers, customs officials, corporate coalitions and private investigators. “Counterfeiting is one of the plagues of a popular brand,” says Leah Evert-Burks, Deckers’ inhouse counsel and director of brand protection. “There are some anti-counterfeiting measures I can’t even talk about. It’s amazing what you go through when you get involved in this world.”

By Deckers’ count, last year the company terminated over 20,000 eBay auctions, shut down over 2,500 websites, and accounted for some 60,000 pairs of counterfeit boots seized by customs officials. While Evert-Burks emphasizes that the vast majority were blatant criminal operations out of China (which often glue inexpensive cow suede to the exterior of the boot in place of twinfaced sheepskin), Stewart says he still receives complaints from Australian vendors who have been lumped in with counterfeiters.

Like a global mute button, the threat of legal action has stifled the Australian ugg industry’s efforts to market internationally. The McDougalls claim to have lost 90 percent of their international business since 2004. Their daughter gave up entirely after Deckers shut down her eBay business. “Almost anyone who sells anything with the word ug, ugg or ugh is infringing on their trademark,” Bronwyn says. “There’s no argument.”

At the same time, however, Conley, or his editors, go to great lengths to be as friendly as possible to Deckers. For instance, he doesn’t actually come out and say that uggs have been a cottage industry in Australia for decades: he feels the need to call them “generic uggs” instead, as though they were somehow copying the Deckers Uggs long before the Deckers Uggs even existed.

What’s more, throughout the article, the Deckers product is referred to in all caps, as an UGG. No self-respecting newspaper style guide would ever allow such a thing, but glossy fashion magazines never had any self-respect in the first place, and it’s clear which side of the line the WSJ magazine falls.

Worst of all, however, is the sidebar, which compares Deckers’ boot to the competition:

The UGG Australia Classic boots come in short (midcalf) and tall versions. Any variation on these heights are not genuine UGG boots.

A genuine UGG has the registered trademark symbol ® next to its logo on the label…

Some fakes use synthetic “fleece”.

My emphasis, but you get the point, which almost tips into self-parody here:

Deckers’ UGG boots are made in China, so if the label says “Made in Australia,” it is not an UGG.

The point is that there are lots of Ugg boots. The most popular Uggs are made by a US company in China. That company owns a bunch of trademarks, which somehow means that the WSJ can talk with a straight face about “genuine UGG boots”, while saying that all other Ugg boots are fakes. But the fact is that an Australian Ugg boot, made by a company which long predates the Ugg trademark, is by any sensible definition just as genuine, if not more so, than the boots that the WSJ is falling over itself teaching us to recognize and distinguish.

Yet somehow Conley feels impelled to inform us that if a boot is made in Australia — the home of the Ugg boot — then “it is not an UGG”.

To give an example of how ridiculous this all is, imagine that an American company — maybe even Deckers, you never know — decided to buy up a small knife-making company in Thiers, France. And say that after doing so, it started to register the name Laguiole, and the famous bee symbol, in jurisdictions around the world.

Deckers then decides to outsource production of Laguiole knives to China, while at the same time slapping anybody else trying to sell Laguiole knives with a cease-and-desist order. It starts impounding any Laguiole knives which are imported into the US, and shuts down any market in Laguiole knives on eBay or in other marketplaces.

Laguiole knives have been made by thousands of French craftsmen for over 150 years, but suddenly there would only be one “genuine Laguiole® knife”, and all the others would, overnight, be branded “counterfeits” or “fakes”; their sales would collapse, while Deckers would essentially hijack all of the brand value which has been painstakingly built up over the generations. And heaven forfend that anybody else try to make Laguiole knives in China — those would get seized at customs, and branded as “blatant criminal operations” by Deckers’ in-house counsel.

If that were to happen, one would hope that the WSJ would try to expose the evil trademark troll, instead of running gushing articles about how the company was serving up “stunning results in the midst of a global recession”. It certainly wouldn’t — one hopes — tell its readers how to make sure they were buying a genuine Laguiole® knife rather than an expensive French “fake”.

Conley mentions in passing, in his piece, that after Deckers lost the lawsuit in Australia, it failed to pay certain legal costs of the winning side, as required under Australian law. If he ever asked Deckers counsel about this, there’s no sign of it in the story. Instead, he concludes with a paean to a highly-successful company:

Although UGG is not the haute couture brand it was years ago—the darling of fashion spreads, the envy of A-list gift bags—its sales are bigger than ever. That “alpha consumer,” the mother picking up her kids at private school in the Range Rover? While she may no longer roll up in a pair of the latest UGG boots, her counterparts at the neighboring public school are pulling away in Explorers full of UGG-boot-wearing adolescents. UGG Australia has become a mainstream brand, always in stock—found in several stores in any mall—and begrudgingly approved of even by its critics for its comfort and utility. It’s an appropriate irony; the humble boot of the masses has come full circle—albeit with a trademark this time. And that’s fashion, according to Simonton. “Things come back,” he says, “but they’re never quite the same.”

Well, “irony” is one way of putting it: the humble boot of the masses is still a humble boot of the masses, but now it’s wrapped up in aggressively-enforced trademarks, ensuring that all the profits from that humble boot accrue to a single multi-billion-dollar multinational corporation. But yes, “that’s fashion”. And you can be sure that a glossy fashion-focused magazine is never going to cut against the grain of the fashion industry when it comes to issues surrounding trademark law and intellectual property.

Which is why it’s crazy that the WSJ tries to cover the fashion industry from within the covers of a glossy fashion-focused magazine. The conflicts are far too big — and, as this story shows, the winner in those conflicts is always going to be the big fashion multinational, rather than the magazine’s readers.

Update: It turns out there already is a Laguiole trademark troll! Thanks to vb2b, in the comments, for the link.


I just discovered this article and it contains a lot of inaccuracies. It also omits several important facts. Before the mid-1990s, when Deckers bought the rights to the “UGG” trademark (and the company Ugg Holdings) from an Australian, and tiny companies with similar names in places like Cornwall and New Zealand, a typical Australian ugg boot “factory” consisted of a shack at the edge of a sheep farm, with two or three people working there — all members of the sheep herdsman’s family. They made, at most a few hundred thousand dollars a year. Ugg boots were considered a lower-class, trashy type of footwear, worn by young suburban thugs called “bogans” who didn’t have any money. The American equivalent term would be “white trash.” In the UK you call them “chavs.”

Then Deckers embarked on a very clever and expensive marketing campaign, giving away thousands of pairs of boots not only to celebrities such as Pamela Anderson, Sarah Jessica Parker, Cameron Diaz and Oprah Winfrey, but also the entourage and fans for each celebrity. They carefully sought product placements in trendy films and TV series. The strategy paid off and Oprah named UGG brand boots one of her “Favorite Things” two consecutive years.

The UGG brand boot is now a high fashion item like Jimmy Choo shoes and Ralph Lauren sportswear. Instead of a few hundred thousand dollars in sales to a crowd of suburban Australian chavs, Deckers has just reached US$1 billion in annual sales worldwide. They have every right to protect the lucrative worldwide market that they have created, because they’re the ones who created it. The little Australian shacks on the edges of the sheep farms have every right to sell their wares in Australia but Deckers planted the seeds in the rest of the world, and now they’re reaping a bountiful harvest.

http://www.pjstar.com/business/x18959986 31/Ugg-kicking-it-in-the-U-S

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Basel III arrives

Felix Salmon
Sep 12, 2010 18:37 UTC

Basel III has arrived! The official BIS press release is here, with a wealth of information inside it. But they conveniently also supply this table, which gets to the core of the matter:


There’s a lot to unpack and explain here. But the first thing to note is that we’ve moved from a simple “Tier 1 has to be 4%, Tier 2 has to be 8%” to a 3×3 matrix with all manner of different minima. It’s a bit more complicated, but it’s also more intelligent, and should be much more effective as well.

Possibly the most important thing here is the existence of the first column, setting minimum standards for common equity — which is also known as core Tier 1 capital. Such standards did exist in the past, but they were set extremely low, at just 2%, and so were generally ignored. As of now, common equity is the main thing that matters. No more throwing any old garbage into the Tier 1 bucket and calling it capital: the new standards for common equity are significantly tougher than the old standards for Tier 1 capital in total.

The absolute bare minimum for core Tier 1 capital is 4.5%, and the new minimum for Tier 1 capital in general has now been raised to 6%. The minimum for Tier 2 remains at 8%.

But that’s just the beginning. On top of that there’s a “conservation buffer” of another 2.5 percentage points; to a first approximation, any bank you’ve heard of is going to want to be well outside that buffer, because they won’t be able to pay dividends if they don’t have the full buffer in place. If there’s some kind of crisis and they’re forced to write down a lot of bad loans, they can eat into the buffer — but that will bring extra regulatory oversight, and they won’t be able to pay dividends. That’s sensible.

With the conservation buffer, then, banks need 7% common equity, 8.5% Tier 1 capital, and 10.5% Tier 2 capital.

And it doesn’t stop there, either. When credit in an economy is growing faster than the economy itself, a countercyclical capital buffer kicks in, which essentially says that banks need to have more capital in good times. That countercyclical buffer won’t be set by the BIS in Basel; it’ll be left up to national regulators. But you can probably expect the UK, US, and Switzerland to enforce it up to the maximum of 2.5%.

So when the economy’s booming, banks are going to need 9.5% common equity, 11% Tier 1 capital, and 13% Tier 2 capital.

But wait, there’s more! “Systemically important banks should have loss absorbing capacity beyond the standards announced today,” says the BIS — we don’t know what they’re going to announce on that front, but the chances are that when an announcement comes, the biggest banks are going to need significantly more capital than what we’re seeing here.

This is all very welcome stuff. But it neither can nor should be implemented overnight. Instead, there’s a timetable built in to the new capital standards:


This is even more complicated, obviously, than the capital standards themselves. But in a nutshell, the standards start being phased in on January 1, 2013, with a core Tier 1 requirement of 3.5%. That rises to the final 4.5% in 2015. Other parts of the structure take longer, but they’re all phased in by January 1, 2019 — which is more than enough time for the world’s banks to raise any extra capital they might need.

Meanwhile, various dubious things which currently count as Tier 1 or Tier 2 capital but shouldn’t will be phased out even more slowly, over a period of 10 years beginning in 2013.

Other key parts of the Basel III regime, which weren’t announced today, will also come during these years: the liquidity coverage ratio gets introduced in 2015, while the net stable funding ratio arrives in 2018.

The banks aren’t going to take all this lying down, but I’m hoping their reaction is going to be relatively muted. This is a done deal, now, and they just have to live with it. And the banks which embrace the new standards and are proud of exceeding them will ultimately be more successful than those which try to get around them. Indeed, it would be great to see non-bank lenders adopt these standards too, on a voluntary basis. Most shadow banks easily exceed these ratios already, and I’d love to see the ones which don’t slowly wither away.


This is just the first step for “too big to fail” (too big to understand also) financial institutions.

They must bear in mind that they will have to do more. Systemically Important Financial Institutions (SIFIs) should have higher loss absorbency capacity.

George Lekatis

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Let’s not bail out more subprime lenders

Felix Salmon
Sep 12, 2010 16:58 UTC

Gretchen Morgenson is absolutely right, in the words of her headline, that “Housing Doesn’t Need a Crash. It Needs Bold Ideas.” The problem is that the bold idea she’s pushing is not the kind of bold idea that housing needs. Meanwhile, she sidles up to a genuinely good, if not particularly bold, idea, but fails to connect her own dots:

Many lenders and some government agencies bar borrowers who sold their homes for less than the outstanding loan balance — known as a “short sale” — from receiving a new mortgage within a certain period, sometimes a few years.

For example, delinquent borrowers who conducted a short sale are ineligible for a new mortgage insured by the Federal Housing Administration for three years; Fannie Mae blocks such borrowers for at least two years. Private lenders have similar guidelines…

68 percent of properties in Nevada are worth less than the outstanding mortgage, CoreLogic said, while half in Arizona and 46 percent in Florida are underwater.

So, the first, easy thing to do is to get rid of the blunt restrictions on lending to people with a short sale in their recent past: the housing market needs all the potential buyers it can get, right now. Once upon a time, it might have made sense to think that people with recent short sales would be such bad credits that no bank should think about selling them a mortgage. But not now, when the presence of a short sale on your credit report is likely to say much more about the broader housing market in your region than it does about you.

Of course, lenders can always refuse any individual for any reason, after doing their underwriting. But there’s no point in having a blanket restriction on lending to people who have done a short sale.

But that’s not Morgenson’s bold idea. Instead, she reckons that Fannie and Freddie should happily step in and refinance — at par — any and all performing subprime mortgages that they can find.

The problem with this is the same as the problem with HAMP: there’s no principal reduction. Without principal reduction, these borrowers will remain underwater on their mortgages, and therefore will remain at very high risk of defaulting.

Think about it this way: the subprime mortgage crisis came about because banks were blindly and happily lending 100% of a home’s value. Now Gretchen Morgenson wants the U.S. government — through Fannie and Freddie — to lend out much more than that: maybe 150%, maybe more. That’s idiotic.

Here’s how the Congressional Oversight Panel characterizes such schemes:

Lack of principal forgiveness means that homeowners will continue to be underwater. It also means that more of each payment will be going to interest, rather than paying down principal, and it may mean that some borrowers have to pay for a longer period of time. All of these factors increase the re-default risk on modified mortgages, and to the extent that a permanent modification is not sustainable, it merely delays a foreclosure and the stabilization of the housing market.

The main beneficiary of Morgenson’s scheme would be the investors and lenders who would jump at any opportunity to take mortgages worth much less than par and sell them at 100 cents on the dollar to Uncle Sam. It’s a bailout of bondholders, primarily, and as such it stinks. These investors, when they lent to subprime borrowers, knew they were taking credit risk. They should suffer some kind of loss now that the market has crashed, and any idea which takes them out at par is fundamentally ugly.


I understand all of Felix’s points, but I don’t think he quite grasps the extent of moral hazard involved if the banks went for wholesale principal reduction as he advocates in this and previous posts.

From a behavioural finance perspective, if we put in place policies that provided widespread principal reduction, then the next credit bubble attached to real estate would be even more severe, as debtors priced in the value of an expected principal reduction should their mortgage go under water, during bidding on properties. This would drive up prices even faster than they normally would go, hurting the people who we should be helping, people who want to buy a home to live in themselves, rather than speculators and flippers.

Over and above that, and on the philosophical level, I have yet to hear a coherent argument that someone who signs a contract for a mortgage loan should somehow be granted a principal reduction just because they are under wanter. The borrower can always exercise their option to mail in the keys and walk away from the home.

Also, it’s not like borrowers haven’t already been granted special benefits due to the “crisis”, The Mortgage Forgiveness Debt Relief Act of 2007 (known by California mortgage brokers are the “Don’t 1099 Me, Bro” law) already allows debtors to do a short sale and then walk away from the short amount without paying taxes on the forgiven/cancelled portion of the debt. Why isn’t that enough?

Posted by Strych09 | Report as abusive

Value vs momentum chart of the day

Felix Salmon
Sep 10, 2010 17:52 UTC

Chart of the day comes from the Bank of England’s Andrew Haldane:


What you’re seeing here is the result of two different investing strategies. The red line is momentum: every month, you do one of two things. You go long the market when the market rose the previous month; or you go short the market if it fell the previous month. The blue line, by contrast, is value: you use a dividend discount model, and buy the market when it’s cheap, and sell it when it’s expensive.

Here’s the results, as presented by Haldane in his speech to the Oxford China Business Forum, in Beijing:

The speculator’s $1 stake in US equities in 1880 would by 2009 have grown to over $50,000. The fundamentalist’s same $1 stake would have fallen to be worth around 11 cents. Impatience would have trumped patience by a factor of half a million.

Gavyn Davies can’t think of any good reason why there should be any outperformance here, let alone anything of this magnitude. I’m inclined to agree with him: I can think of a couple of things which might be going on, but none of them feel particularly convincing.

Still, both of these strategies involve going both long and short. Stocks generally go up over time, so in general a strategy which goes long more than it goes short is likely to outperform a strategy which goes short more than it goes long. If the dividend discount model has even a modest overinclination towards concluding that stocks are overpriced, it’s going to get crushed: you don’t know pain, in the markets, until you put on a short position and watch the stock you borrowed crawl inexorably upwards.

For real people, long-short strategies are nearly always contraindicated, no matter how profitable they might have been in the past. And this chart only serves to underline that fact: the sensible, fundamentals-based strategy is disastrous, while the crazy crowd-following strategy, which ought not work at all, turns out to be highly profitable. Still, I would have loved to see a third line, showing the results of a simple buy-and-hold strategy. Sometimes the easiest things to do are also the most profitable of all.

Update: Many thanks to Jake, who has come up with a whole series of new charts comparing these numbers to a buy-and-hold strategy. Here’s one:



Felix – FYI…posted a follow up to Haldane’s strategy here:

http://marketsci.wordpress.com/2010/09/2 0/re-the-power-of-momentum/

In a nutshell, it’s a dud because Shiller’s S&P 500 price represents the AVERAGE price for the month, not the month-end.

That means it’s not reproducible (and completely falls apart when applied to actual prices).

Just my small contribution to the discussion.


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