Rollback of the Basel Accords Is Key to Trump's 3% Growth Goals
Despite the soap opera that has become Washington, the Trump Administration will likely succeed or fail on whether it can reignite U.S. economic growth. Regulatory rollback is a big part of its get-America-moving-again agenda, perhaps the biggest, if Congress remains frozen. But while the Administration has made good progress reversing the regulatory overreach of the Obama years, one cluster of mandates could still kill its hope for annual GDP growth that tops three percent -- the U.S. financial rules implementing the international Basel Accords.
Enforced in our country mostly by the Federal Deposit Insurance Corporation through tis bank examiners and created to make the global financial system more stable, three decades of ever-tightening edicts have profoundly changed American and global banking, triggered repeated economic downturns and stunted business and job creation. These rules should be unraveled.
Three times since the late 1980s the Basel rules have compelled banks to increase their capital-to-loan ratio. Each time, because of fire sale conditions that the everyone-in-the-pool commands created, complying institutions rarely issued new stock. Instead they limited their own lending. As Cato Institute economist Steve Hanke and Institute for International Monetary Research chairman Tim Congdon recently explained, U.S. Government issued this kind of order in the fall of 2008. The result was “a drop in lending to the private sector … the quantity of money in the economy fell…. The stock of loans actually went down during the first two years of this period….”
But thanks to the Basel rules, regulation-induced credit tightening also happened from 1988 to 1992, triggering, many economists believe, the 1990-1992 recession. It happened again from 2004 to 2008, and the Great Recession began in the last two years of the compliance period. The panic-induced 2008 boost in capital requirements simply made a bad situation worse.
Why does this matter today? The '88-'92 tightening applied to just a handful of major multinational institutions; the '04-'08’ round reached to large regional banks. But beginning in 2013, Basel-Agreement-driven, FDIC-enforced tightened capital standards began to be applied to U.S. community banks.
We are now six months nearing the final two years of this third mandate, meaning, if past patterns hold, we will soon – if we have not already -- see slower or shrinking lending from community banks. Community banks write a major share of America’s small business loans. Historically, though not recently, small and medium sized businesses including start-ups have been the nation’s major source of new jobs. If America is to generate larger new-job numbers, these smaller banks must have expanded, not restricted, license to lend.
But it is not just the widening reach of its capital requirements that makes the Basel rulebook so dangerous, at least in the entrepreneurial United States. It used to be that banks of all sizes wrote business loans based primarily on their own assessment of a company’s strength. No longer.
The Basel rules require rating borrowers by broad categories. The riskier the category, the more capital an institution must reserve against a loan – a powerful incentive that shapes all bank portfolios subject to it.
Starting with the first Basel Accord in the late 1980s, governments were ranked the safest borrowers. No capital needed to be put up against their debt. Instead, government bonds were classified as bank capital, which surely contributed to European banks loading up on high-interest-rate Greek paper.
Mortgage-backed securities were rated the next safest. Almost no capital needed to be set aside against them. American Enterprise Institute scholar of the financial crisis Peter Wallison attributes the enormous pre-crash appetite of US banks for these derivatives to the preference. Those holdings and the mark-to-market rule (another Basel mandate) set up American banking for a crisis.
As for small-and-medium-sized businesses (SMEs) and start-ups, Basel lumped them with the most disfavored borrowers. The European Union negotiated some modifications for its SMEs, but in the US the result was an across-the-board winding down of SME lending. Bringing community banks under the restrictions will make the retreat even worse.
During the long economic growth of the 1980s and ‘90s, the American financial system was uniquely friendly to start-ups and SMEs. That changed not just with the expanding reach of the Basel Rules since the late ‘90s, but also Sarbanes-Oxley, Dodd-Frank, and a general hostility to financial risk of the post-financial crisis Securities and Exchange Commission. These were all massive mistakes. Undoing them is an essential step to restoring vigorous and enduring prosperity to America.
