How safe will our banks be after Basle III?

19/11/2010 by

Woefully unsafe,  I am afraid! Here is why:

The original Basle I&II regulatory regime for banks did nothing more than to specify a simple minimum capital ratio; the minimum permitted ratio between capital and bank assets. The bank was seen as a trader in credit. Borrowing and lending  at a spread. Regulation was all about forcing the banks to hold on to some money so that if they were to suffer losses, then they could absorb them. Why must minima be imposed upon the banks? Because they are greedy and they know that the more money they must keep in their vaults the lower their profits. Idle money, sitting in the bank’s vaults, are anathema to bankers. They know that, when unexpected losses occur, they will be in trouble. But they also know that the government will rush to their aid, fearful of what will happen if a bank run takes place and public anger erupts the moment ATMs start reporting ‘insufficient funds’ (not the customers’ but the… bank’s). To avoid this ‘moral hazard’, as economists so quaintly put it, regulatory authorities impose restrictions on capital or leverage ratios.

The problem is, however, that the bankers are better at bamboozling the regulators than the latter are at imposing their will on bankers. The reasons are varied but, in the final analysis, it has to do with the infinitely greater resources at the disposal of bankers in their struggle against regulators. This struggle boils down, eventually, to the way in which bankers manage to interpret the regulations and to ensure that the latter are confirmed more in the breach than in the observance. More precisely, the promote definitions of capital and of assets that allow them to report a healthy leverage ratio when, in reality, they do as they please.

The recent Basle III agreement was heralded as an important step in tightening up regulations to ensure that banks cannot get away, at least not as easily, with murder. While it was acknowledged that allowing them eight more years to comply to the new rules is excessive (the new rules do not come in force until 2018), most commentators welcomed the news that Basle III forces the banks to triple the amount of best quality capital that they must retain at all times to cover for future losses. That ratio will stand at 7% from 2018 onwards.

In the following lines I shall explain why this is nothing less than a hoax; a charade; a trick of the tail. But first I shall give Basle III its dues for the one change it brought in that is appropriate: the new definition of capital. Basle II allowed banks to count in non-existent capital and to treat it, for regulatory purposes, as really existing capital. For instance, deferred tax assets were counted as money already in the bank when it was not really there and would have been useless in case of a crisis (echoes of Enron here, for those with longer memories than the current commentariat). Basle III stopped that.

Unfortunately this is where the good news ends. The capital ratio, as explained at the outset, is the ratio of capital over loans (or assets, as they are called to allude to the fact that the banks’ greatest asset is the money that clients owe it). As conceded in the previous paragraph, Basle III ensured that the nominator of that ratio is fairly computed. But what about the denominator? And here lies the rub. Banks will continue, even after 2018, to carry out one of the trade’s great swindles: To ‘risk-weight’ their assets, or loans. In short, to under-report them massively. Here is what ‘risk-weighting’ means: Suppose the bank lends you €300 thousand to buy a house. How much will the denominator of their capital ratio increase by? The naive will answer: €300 thousand. Wrong! The true answer is: By as much as the bank wants. “How can that be?”, I hear the incredulous reader ask. Well, the bank’s argument, that Basle III will heed (just like Basle I&II did), is that there is no way on earth that it can ever lose all its money even if you can’t pay the debt off. After all, the bank has collateral (your house) which it can pawn off and recoup a large chunk of the failed loan. Of course, this depends on the state of the real estate market when and if your home gets auctioned off. How much will it fetch at auction is anyone’s guess. Well, the bank chooses what it wants that guess to be and, unsurprisingly, it chooses to think that it will certainly recoup at least, say, €250 thousand. So, even though it has loaned you €300 thousand, it ‘risk-weights’ this down to €50 thousand and adds only that small figure to the denominator of its capital ratio.

Things are even worse when it comes to other types of loans. For instance, when the banks lend governments (by buying government bonds), these loans are assumed to be risk-free. So, even if a bank forks out billions to buy German or French bonds (or even Irish and Greek bonds back in the pre-crisis days), guess by how much the denominator of its capital ratio increases: Yes, you guessed right: By precisely zero! In fact, any loan offered to an institution with a triple-A rating granted by one of our infamous credit rating companies does not count as a loan. Since it is assumed next to risk-free, it is ‘risk-weighted’ as a zero loan and a big fat zero is added to the capital ratio’s denominator. That was the practice before Basle III and it will remain so after Basle III comes into play after 2018.

So, how safe will our banks be after 2018? Brace yourself good reader for you are in for a shock! The answer is: Much less safe than Northern Rock was weeks before its spectacular bankruptcy. To see this, let us consider some facts. as already explained, Basle III will force, from 2018 onwards, the banks to hold 7% of their ‘risk-weighted’ assets in good quality capital. But who determines the all important ‘risk-weight;? As before, the banks themselves! So, let’s take a look at Northern Rock as a benchmark. Northern Rock had 100 billion pounds of assets which they ‘risk weight’-ed down to 19 billion (in the manner outlined in the previous paragraph). So their 2 billion pounds of capital led to a capital ratio of around 11%! Of course in reality Northern Rock’s leverage ratio was a measly 2%. And when it incurred losses of above 2% of its assets, the first bank run in Britain for 150 years was on and Northern Rock’s end nigh.

In conclusion, it ought to give us pause that Basle III gives banks eight years to become less safe than Northern Rock was weeks before it collapsed. Moreover, we Europeans have greater cause to worry since Europe’s banks have the thinnest capital ratios in the world. Just when we thought it was safe go back in the financial pond… [the Jaws theme ought to come in somewhere here]

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