The Basel II concept leads to a false sense of security

Posted by on 5 February 2010

 The Basel II accord has done more harm than good for stability. In a previous post last month on the failure of financial regulation, I pointed out that Basel II has glaring deficiencies that virtually provide a navigational map to creating off-balance sheet instruments.

 
The regulatory incentives regarding capital requirements in Basel II contributed to the subprime crisis. It gave banks incentives to:
  • “originate and distribute” as opposed to originate and hold
  • securitise every asset and buy it back without changing the credit risk profile
  • use credit default swaps to reduce capital requirements even further
  • stuff toxic securities into structured investment vehicles        
 
All of the off-balance sheet activities that led to the financial crisis were backed by stand-by loan commitments with (rolling) maturities under one year that are given a zero risk weight under Basel II.
 
In short, numerous observers, such as the Shadow Financial Regulatory Committee (a group of publicly recognised, independent experts on the financial services industry) have reached the conclusion that the Basel II concept -the theory that only mathematics (addition, subtraction, multiplication, and division) is necessary to capture risk- leads to a false sense of security. It pre-empts judgment in favour of the lowest common denominator - simplistic risk maths at its worst-and is complicated, with provisions running to hundreds of pages. Billions of dollars have been spent implementing this futile framework, and all that remains is an edifice that is artificially supported to salvage the credibility and reputations of the regulators.
 
The regulatory bodies and central banks have decided how to improve the Basel accord, and the Basel Committee has circulated a consultative document on strengthening the resilience of the banking sector with new proposals on capital and liquidity “buffers.”
 
Most of the proposals look sensible. However, while the revised accord creates more robust capital standards, it does not address one of the most glaring problems with Basel I and II. Sovereign debt is treated as before. The risk weights for sovereign debt denominated in foreign currency is based on the sovereign credit rating: AAA to AA (0 per cent risk weight), A+ to A- (20 per cent risk weight), BBB+ to BBB- (50 per cent risk weight); and BB+ to B- (100 per cent risk weight).
 
In light of the fact that some people consider the credit rating agencies to be discredited, one might have serious doubts about the ratings of sovereigns. More importantly, according to the Basel accord: “At national discretion, a lower risk weight may be applied to banks’ exposures to their sovereign (or central bank) of incorporation denominated in domestic currency and funded in that currency.” I am not aware of any country that imputes a risk weight on its debt. All countries assign a zero risk weight to domestic currency debt. One does not need advanced risk management training to recognize the warped incentives implicit in this approach. What are the consequences?
 
Recent financial history is rife with crisis and default on local currency debt: Mexico’s debt crisis (1994-95), Argentina’s government debt default (2001), and Russia’s default (1988), among others. We are all cognizant of how difficult it will be for Greece to stave off a sovereign debt default. A Greek sovereign default would probably lead to contagion and affect other vulnerable eurozone countries such as Ireland, Spain, and Italy. I am not aware of any recent comments that object to this problem in the Basel accord that exists since Basel I, a reflection of resignation and apathy.
 
International and domestic regulatory authorities are creating warped incentives to encourage the purchase of sovereign debt. What are the implications of an accord that once again allows countries to give zero risk weight to sovereign domestic local currency debt, creating the illusion that such debt is risk free? Economist Steven Landsburg observed, “Economics can be summed up in four words: people respond to incentives.” “The rest,” he said, “is commentary,” and he was right.
 
There are severe consequences to encouraging banks to accumulate local currency sovereign debt in both emerging markets as well developed countries.
 
First, we already know that there is a global shortage of bank capital and that credit is slow to grow in the aftermath of a crisis. Therefore banks short on capital and reluctant to lend in a risky setting are given an easy choice to pile into government debt.
 
Second, banks simply borrow from liquidity lines and invest in government debt; zero interest rate policies in effect transfer a very large amount of money risk-free from the public purse - the liquidity support of the central banks - to the coffers of banks. This big transfer is funded by the average citizens in the crisis-stricken countries who make a few meagre tens of basis points on their savings.
 
We are told (by Lloyd Blankfein, Goldman Sachs chairman) that banks “have a social purpose”: “We’re very important …. We help companies to grow by helping them to raise capital. Companies that grow create wealth. This, in turn, allows people to have jobs that create more growth and more wealth. It’s a virtuous cycle.” But it is not entirely clear how fiscal deficits funded by government debt and held by banks are conducive to a virtuous cycle.
 
Once banks are seduced by the safe profits from intermediating government debt, they lose the institutional capacity and motivation to search for suitable credit risks and do “God’s work.” In developing countries, we have seen this situation for a long time and coined a phrase for it: “lazy banks.” African banks, which mostly intermediate public debt, are some of the most profitable in the world. In India, public debt accounts for a very significant share of the banks’ portfolios.
 
The ultimate macroeconomic outcome of portfolios stuffed with government debt is a slowdown in credit intermediation and growth. According to the International Monetary Fund, government debt for advanced G20 countries will reach 118 per cent of gross domestic product on average by 2014. Among them, only Australia, Canada, and South Korea will have debt ratios well below 90 per cent (IMF Staff Position Note, November 3, 2009.
 
By 2016, the conditions for a new systemic crisis- this time sovereign -might be in place. What is unique is that, while defaults on sovereign debt occurred before Basel I and II, this time regulatory authorities are actively encouraging banks to take refuge in government debt. So why is the Basel Committee insisting on calling local-currency-denominated sovereign debt risk-free? I don’t know.