It's Time to Discontinue the Basel Regimes
Before the G20 approves the Basel III capital regime this week, it should take a moment to examine the logic of Basel, what has happened under Basel II, and the potential future under these regimes.
Every time there is a crisis, critics of the financial system recite a standard complaint: There is too much risk in the system, and a new capital regime is needed to ensure that risk is eliminated and de-incentivized if another financial crisis is to be prevented.
The critics have it exactly backwards. In an attempt to curb risk, regulators must necessarily create more of it, exposing the financial system to more frequent and severe crises. It is not a question of execution.
In fact, not only are more stringent capital regimes unable to prevent crises, but the more thorough their implementation, the more severe the resulting effects will be, while regulatory forbearance will delay crisis and ameliorate the ill effects to some degree.
The key to resolving this paradox lies in understanding the nature and dynamics of the free market. A market downtrend initially tends to feed on itself because failures in some corner of the market put a strain on related factors. However, there is a limit to this self-reinforcing cycle, because there is an intervening force.
At the point when falling prices begin to look attractive relative to value, those market players who did not fail begin to purchase the assets of those who did. They thus set a market bottom and lay the foundation for a market reversal. This is the self-correcting mechanism of the free market.
Basel undercuts this mechanism. The regime is designed to make banks less risky by forcing them to raise capital in proportion to the degree of various risks, not merely internal to the bank, but in the financial system at large.
These risks may manifest as failures in the market, market distress signals, debt defaults or downgrades, and falling asset prices. The application of government force to ensure that financial institutions raise capital means the forced sidelining of capital which would otherwise be deployed to set the market bottom.
This is a violation of the right of bankers to exercise their business models as they see fit, and the regime should be abolished on those grounds alone. As the laws of the universe would have it, that which is immoral is also ultimately impractical.
Not only is less capital available to rescue the market from perpetually declining prices, but the problem with Basel goes even further, and a dangerous situation ensues: The only practical way for institutions to raise their capital levels is by shedding assets, but asset disposals lower the price of assets, reducing capital levels and raising risk levels in a positive feedback cycle.
Basel is pro-cyclical. It is designed to lessen systemic risk, and instead causes it.
The regime was built on the notion that increased capital levels provide a buffer against insolvency, but a moment's reflection reveals this to be pure superstition. No level of capital requirements is inherently superior to another, and none have some intrinsic protective effect.
Capital requirement levels represent the fiat of man, not a requirement of economic reality. In reality, what is important is the overall direction of the banks, or the relative changes in capital levels, not the absolute levels.
If a bank experiences losses and falls short of capital standards, it can regain capital as conditions improve. If a liquidity crisis or write-down spiral occurs, the nominal levels of capital are irrelevant, because the problem is that capital levels are falling under whatever the requirements happen to be.
There are thus two wrong courses of action when modifying capital regimes. One is to make significant restrictive changes, because it causes mass pain. The other is to put in place a regime which causes a positive feedback loop. As long as there are capital rules, the standards should be fixed and concrete, not fluctuating or linked to some condition. The Basel II Basic Approach fails the first, and the Advanced Approach fails the second. Basel III fails both.
The credit crisis in Europe earlier this year was characterized by illiquidity, a constrained credit supply, and a market correction as institutions scrambled to raise capital. Potential government defaults clearly precipitated the turmoil. However, as the sole explanation, this is problematic.
Defaults are delimited events because the financial system readily absorbs credit losses, even very large ones, through general growth. The liquidity crisis should have abated as default probabilities were factored into prices relatively quickly. Yet, the size and persistence of the market drop were greater than what would be expected from historical sovereign debt defaults.
Austrian economic theory is useless as a causal explanation here; the European Central Bank had not been looser than others, and if it had suddenly tightened or undertaken radical operations, the market would have known it immediately. Further, inflation remains low despite staggering deficit levels.
Monetarists in the U.S. are perplexed because quantitative easing by the Fed is not removing the threat of deflation or alleviating tight credit conditions since the recovery. Keynesians have no explanation for why massive stimulus spending in multiple countries has no apparent effect on increasing the velocity of money.
The explanation and the cure are not complicated. The recent European credit crisis, like the financial crisis, was centered on bank balance sheets. The cause was therefore something which affected bank balance sheets, recently preceded the crisis, and was unique to Europe.
Basel II, which went into effect in Europe on January 1, 2008, is the most obvious candidate. At the time of its introduction, its effects were masked by the financial crisis. When mark-to-market rules were eased, Basel II enhanced the resulting reflation and thus put aside, for the moment, questions about its perils.
The financial crisis significantly slowed the economies of Europe, however, and European government debt began to show signs of distress in late 2009. In mid-April, a liquidity crisis broke out on the continent. Europe pressured the U.S. stock market as it sold U.S. assets to stabilize, but the regime was otherwise applied weakly enough that market forces could overcome its pro-cyclical tendency. Interestingly, on April 1, U.S. banks began Basel II parallel reporting-the results of which were potentially actionable by the major banks-in preparation for transition to Basel II after the end of this year. (Contrary to popular myth, the U.S. is not currently on Basel II).
Unlike Europe, the United States will not have a major non-Basel II market from which it will be able to procure mandatory capital when "systemic risk" is present, and the strength with which regulators apply the regime will determine how serious the trouble will be when U.S. states begin defaulting or showing imminent signs of default. The recent elections in California and New York reveal polities with a malignant and recalcitrant entitlement mentality. These states, and possibly others, will not shore up their finances. They are headed for debt downgrades and/or defaults.
When that happens, U.S. financial institutions will begin selling off assets to meet increased capital requirements due to "systemic risk," and the government will engage in a flurry of rescue activity. The dollar will initially be devalued as bailout packages are arranged, monetary measures are executed, and investors sell off the currency. Eventually, however, the force driving illiquidity will overwhelm the devaluation forces, and deflation will result as actual losses begin to spiral.
Basel III will facilitate this outcome, and not merely because its capital requirements are more stringent than Basel II. Basel III does not require capital reserves on the highest grades of government debt. Governments have been spending irresponsibly, and investors are rightly questioning whether governments will be able to pay back their debt.
Apparently written to maintain the flow of capital into government bonds, Basel III does not count high-grade government bond leverage against equity. Governments no longer have to compete with the private sector for limited capital, and banks are essentially free to lend as much as they want to governments.
This is a classic pyramid scheme. Governments will view the continuing investment as a sign that the market thinks there is no danger and that conditions will improve, and they will spend the extra money rather than pay down debt. In reality, what banks are counting on is taxpayer bailouts when governments inevitably default.
At that time, banks will argue that the financial system will collapse if the money is not paid back. Ask yourself why else investors would eagerly snap up Greek debt at this time. The open question is how quickly taxpayers catch on to this scheme, and whether the political backlash will be so severe the next time that politicians dare not bail out the financial system.
If they do not wish to court this kind of trouble, governments must do two things. First, they should reject Basel III, suspend Basel II, and put a modified Basel I back in effect until a more permanent solution can be found. They should not bother tweaking the regime to try to blunt its pro-cyclical effects. That would amount to a lie. One cannot both increase reserves and restore liquidity to the market at the same time, and any gimmick which alleviates liquidity problems contradicts the central purpose of the regime.
Financial institutions should not be given a choice in the matter. They will not be forthcoming about any ill effects from or concerns about the regime. Most have adopted the Advanced Approach, which is sufficiently ambiguous that banks have reason to believe they can game the system.
They also have fiduciary obligations to their shareholders to put on a publicly optimistic face, and reputational concerns are behind their support for official schemes, not genuine confidence. The banks who enthusiastically trumpet regulatory schemes are the ones who believe they can arbitrage the dislocations and kill off competitors in any ensuing chaos.
It is important to realize that nine out of 10 banks may game the system and succeed in meeting the new capital requirements. If one in 10 cannot, there will be another financial crisis.
Second, pundits and government officials must change the way they think about risk. Instead of viewing risk as an evil, they should view it as a facet of nature and a precursor of economic growth.
They should reject the utopian philosophy which holds that sufficient improvements in capital rules can produce a safer or more stable financial system. Rather than trying to stamp out risk, they should appreciate its importance and get comfortable allowing the private sector to measure and mitigate risk according to its own judgment.
