Why the Basel change was a bad idea

By Felix Salmon
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
7 comments so far

An interesting take on the lack of liquidity that stimulates thought on the same lack in the economy generally. While there is a lack of sufficient lending to smaller businesses who want to grow, I believe the growing problem is the rapidly accumulating cash piles in large corporations, particularly the low tax paying multi-Nationals. As they dominate more and more of each of their respective markets, they suck out cash from the wider economy and act as a dampener on growth.

As far as banks go, the successive Basel Accords have increased the need for banks to be more solvent, and they have used more of their profits than they needed to do in the past to build up reserves. This *has* taken money away from economic growth, although it could be argued more damaging to the economy generally are politicians so desperate for power for *their* party they so disparage their opponents running of the economy that it scares people out of spending money. In a consumerist society, that is a bad thing.

Your closing remark about the effect of the recent changes making banks riskier over the long term implies that is a bad thing – but is it really? Which is more important, the circulation of money within an economy, or its accumulation as treasure to be set against rare events that happen once every lifetime?

Posted by FifthDecade | Report as abusive

Capital requirements are 10x more important than liquidity requirements. During times of crisis central banks and the government can provide liquidity with a few keystrokes using traditional support measures that are ready to deploy on a moments notice.

It’s an order of magnitude harder and risker for governments to try and solve the solvency issue.

Fear not for weak liquidity controls.

Fear greatly for weak capital requirements… for they insure the TBTF’s will be back hat in hand some day threatening the end of the world.

Posted by y2kurtus | Report as abusive

The broadening of what counts as a “liquid” asset seems pretty mild, considering that 1) steep haircuts are applied to the new asset types and 2) in aggregate, the new asset types can comprise no more that 15% of liquid assets – after haircuts. The reduction in outflow rates looks far more significant to me.

Having said that, what is your answer to y2kurtus? Back in the 19th century, Bagehot argued – correctly, in my view – that Britain’s monetary arrangements were the source of much of her prosperity. In particular, that the provision of liquidity was the role of the central bank. What has happened in the 21st century to vitiate this argument? It looks reasonable to expect central banks to provide liquidity against this small fraction of questionable assets at the mandated haircuts.

Posted by Greycap | Report as abusive

I concur with both y2kurtus and Greycap. Banks obviously need some liquidity, but the true protections against bank runs on solvent institutions are deposit insurance and access to central bank lending.

As for requiring banks to keep large amounts of cash and cash-like instruments on hand – “A ship in port is safe, but that is not the purpose of a ship.” A basic purpose of banks is maturity transformation – turning short-term deposit liabilities into longer-term interest-earning assets (traditionally loans).

Posted by realist50 | Report as abusive

The not-quite-so-obvious answer to what Greycap asked, rhetorically, “Bagehot argued that Britain’s monetary arrangements were the source of much of her prosperity. In particular, that the provision of liquidity was the role of the central bank. What has happened in the 21st century to vitiate this argument?”

Globalization. Multinational corporations.

No taxpayer in Walter Bagehot’s Britain was called upon to provide cover to bets gone bad made by a citizen of another country working for a multi-national non-bank institution like U.S. taxpayers had to pony up billions of U.S. dollars to cover the bad bets made by Joseph Cassano and his band of malefactors at A.I.G. Financial Products.

Furthermore, what The U.S. Federal Reserve and The U.S. Treasury did during the so-called financial crisis to backstop foreign banks and non-bank companies could hardly be called just providing liquidity.

Wall Street banksters and their apologists want to call what happened “providing liquidity” so as to cover up the wholesale robbery of U.S. taxpayers.

Posted by Strych09 | Report as abusive

Liquidity is money. And anything the central bank accepts becomes money. Defining mortgage-backed securities as liquidity implies that the central bank will convert it to cash when needed.

Posted by brg | Report as abusive

1. The LCR will be introduced as planned on 1 January 2015, but the minimum requirement will begin at 60%, rising in equal annual steps of 10 percentage points to reach 100% on 1 January 2019. This graduated approach is designed to ensure that the LCR can be introduced without disruption to the orderly strengthening of banking systems or the ongoing financing of economic activity.

2. During periods of stress it would be entirely appropriate for banks to use their stock of high quality liquid assets (HQLA), thereby falling below the minimum.

3. Banks will be able to count a much wider variety of liquid assets towards their buffers, including some equities and high-quality mortgage-backed securities.

4. European and American banking stocks surged because they will incur much reduced costs due to the implementation of the relaxed rules.

5. Banks in many other counties will have no benefit, as supervisors have already asked for strict liquidity rules, and they are not willing to take it back.

6. On the negative side, the main objective of Basel iii is to restore investor confidence. The Basel Committee has developed the new framework as a response to the crisis, and has explained (time and time again, every month since November 2010) the need for these strict rules.

Although it is true that Basel iii is an overreaction to the market crisis, it is way too late now to “ease” the rules and make investors happy the same time. This is simply a red flag for investors, leading to the conclusion that banks could not really comply.

I agree with the Liquidity Coverage Ratio (LCR) Basel iii amendment, but I cannot agree with the way it was presented.

George Lekatis
Basel iii Compliance Professionals Association (BiiiCPA)

Posted by GeorgeLekatis | Report as abusive
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