Why the Basel change was a bad idea

January 9, 2013

Monday’s Counterparties email went out under the headline “QEBasel“, which may or may not have been an effective way to communicate that the latest relaxation of Basel rules was emphatically done with monetary policy in mind, rather than regulatory prudence. Under the new rules, it might take banks longer to get to a truly safe place, but at least those banks will (we fervently hope) lend more in the meantime, giving a much-needed boost to global growth.

Interestingly, the press reacted very badly indeed to the announcement, which means that Andrew Ross Sorkin, in defending the new rules, is fighting a lonely battle.

He doesn’t do so very well, it must be said. He quotes one John Berlau saying that implementation of Basel as written “almost certainly would have thrown the U.S. and other economies into a recession”, and then says that “Mr. Berlau is right”. Well, Mr Berlau is not right: according to the Basel timetable, very little has to be done this year — and in fact nothing with a 2013 deadline has actually changed at all. The problem with Basel III was never that it would cause some kind of sudden stop in capital flows from banks to borrowers, the minute that it started getting implemented.

And Sorkin also undermines his one genuinely good point. “The chances of a leverage-induced crisis from Wall Street banks right now is quite low,” he writes — and he’s right about that. Indeed, the chances of any leveraged-induced crisis any time before 2019 are very slim indeed. (For one thing, there isn’t enough time, between now and then, to get out of our present slump, find ourselves in a boom, watch the boom get out of control, and then see the boom spectacularly implode.) But here’s the problem: Basel’s leverage requirements haven’t actually changed at all. It’s the liquidity requirements which have changed. And while I’m not worrying about banks’ leverage, I am worrying about their liquidity.

Here’s the difference: leverage requirements protect banks against a sudden drop in the value of their assets. Liquidity requirements, on the other hand, protect banks against bank runs. And bank runs are all about trust and confidence. Banks, especially in the US, might have reasonably strong balance sheets these days. But no one trusts them, or their accounting. (If you don’t believe me, just read Jesse Eisinger and Frank Partnoy in the Atlantic, then you will.) When you don’t have trust, you need liquidity to make up for it — which is why the liquidity requirement is exactly the wrong place for the Basel committee to be fiddling.

What’s more, the Basel committee didn’t just delay the implementation of the liquidity requirements: they changed the requirements themselves. Liquidity is not a completely well-defined term, but it basically means money, or something very very close to it. But the Basel committee has now given up on saying that you need cash, or government bonds, to count against your liquidity requirement. Now, you can even use mortgage-backed securities, if you have enough of them: the rule is that $100 of mortgage-backed securities provide the same amount of liquidity as $50 of cash.

This is a bit silly. If you owe me $50, I’ll accept $50 in cash. In a pinch, I’ll accept $50 in government debt. But I’m not going to accept mortgage-backed securities, any more than the merchants in Times Square accepted a gold bar in lieu of fiat money. The point about liquidity is that it’s money, and mortgage-backed securities aren’t money, they’re securities, which may or may not be easily converted into money at any given point in time. During a liquidity crisis, it’s entirely possible that such things could lose their bid entirely, and that they would therefore be useless in during a bank run.

Another problem here is that the change was not communicated well at all. It was put forward as a significant change in the international system of bank regulation — which is exactly what it is. And as such, it clearly makes bank regulation weaker, and the chances of a crisis some tiny bit greater. But the regulators didn’t change the rules because they thought that the rules were too stringent before; they changed the rules because they wanted banks to lend more, and thereby boost the economy. They just didn’t effectively say what they were doing, with the result that the financial press took the announcement at face value, rather than greeting it as another heterodox way of trying to use central-bank policy to generate economic growth.

The central bankers certainly should have been up-front about what they were doing, because it has important implications. For one thing, they’re playing straight into the hands of the banking lobby. Every time anybody proposes a new bank regulation, no matter how small, the ABA and the IIF and other banking-industry lobbyists will start screaming that the new regulation will depress lending, which in turn will hurt the economy; the clear implication is that even if a regulation makes perfect logical sense from a safety-and-soundness point of view, authorities still shouldn’t implement it if it will reduce the flow of credit from banks into the economy at large. That’s just not true: safety should always come first. But the Basel committee seems to have implicitly accepted that the argument does have validity.

More generally, the committee has clearly determined that if you’ve run out of ammunition in terms of interest rates and quantitative easing, then when you’re searching around for some other monetary-easing tool, regulations are a reasonable place to look. And I really don’t like that precedent. Monetary policy should be entirely separate from bank regulation, even if central banks should properly perform both roles. With the ink barely dry on the Basel III agreement, now is no time to start diluting it for the sake of some hypothetical temporary future marginal boost to growth.

After all, we have no particular reason to believe this stunt will even work. Banks have more than enough liquidity already, to meet the requirements, and they don’t seem to be very keen to lend it out. Sure, the new rules will allow them to lend out that cash, if they want to. But the market right now is rewarding the conservative banks, and punishing those who lend to Main Street. Changing the liquidity rules won’t change that. It will just make banks that much riskier over the long term.


Comments are closed.