Basel 3 - fussier but still flawed

How can you regulate a belief?

The causes of the financial crisis are many and interrelated, but at the heart of the bloated banking machine in the run up to the crisis laid a very simple but destructive belief: house prices would keep on rising. With such a powerful belief, how can risk properly be assessed? The notion that house prices could fall was a blind spot in the computer models – a variable that stood in the way of clear conclusions. While risk management is important to any organisation, it is not definitive, and therefore some basic human judgement should be displayed. Just think how wrong Sat Nav can be, and yet people let computer models “drive” the economy? A solution agreed by many countries in response to the financial crisis was to implement Basel 3. As much as I may appreciate the need for tougher regulation, I feel uneasy with a central theme of the Basel Accords: risk weighted assets. Not only is the methodology for calculating total risk weighted assets overly complicated and fussy, it involves arbitrary weightings which bear little resemblance to actual risks – we’ll allocate 50% to this and 100% to that – and it allows banks to calculate their own risks – like allowing “recovering alcoholics to monitor their own abstinence” (efinancial news). And surprise, surprise, the Basel committee identified “material variability and inconsistencies”. According to the BBC, large banks not only assign varying risk weightings to their mortgage books but they attach weights significantly below those advocated by the standardised approach. Lloyds allocated 16% risk weight, for example, is significantly less than the minimum 35% advocated by Basel 3.

Sat Nav overrides common sense (picture courtesy of Telegraph.co.uk)

A problem with the standardised approach for risk weights is that risk weights change over time and what is risky today will not necessarily be risky tomorrow – not that long ago AAA structured securities received a 20% weighting (before they turned out to be junk). Standardised risk weights distort investment, encouraging investment in already “safe” assets and discouraging investment from other assets (for example loans to new companies), which may be risky but surely are vital to a healthy, functioning economy? My biggest fear with the Basel Accords is they encourage banks to seek new and innovative ways to reduce their risk weighted assets (and innovative doesn’t necessarily mean safe!). An OECD paper shows how the implementation of Basel actually led banks to continuously reduce their ratio of risk weighted assets to total assets from 1991 onwards right up to the financial crisis. The banks were supposedly becoming safer whereas in reality they were pursuing “unconventional business practices” to get around the regulatory regime (think credit default swaps for example). The entire concept of risk weighted assets is flawed and should be scrapped. I support the idea of Thomas Hoenig, vice chairman of the Federal Deposit Insurance Corporation (FDIC), who advocates “replacing the unmanageably complex Basel risk-weighted standards with a tangible equity capital ratio of around 10 per cent” (FT). It was normal for banks to have this ratio before deposit insurance was introduced so it seems like a credible ratio. The beauty of this ratio is its simplicity – no overly fussy risk weighting – rather a simple ratio which within its boundary, banks can invest in whatever assets they deem fit. 10% may seem overly restrictive but not only does this ratio allow banks to be well capitalised, it constrains against large leverage ratios. The 3% leverage ratio advocated by Basel 3 is incredibly low and according to Thomas Hoenig “about the same as that of the largest US banks when the global crisis erupted”. Banks aren’t keen on raising equity claiming it is more costly than debt but decreasing leverage actually makes banks safer therefore lowering the cost of equity; their argument is flawed.

Everything carries a risk weight (picture courtesy of fineartamerica.com)

Higher equity is essential for the future health of the banking system. While Basel 3 may demand a much higher common equity Tier 1 capital ratio (7% instead of 2%), if banks are still able to find ways of reducing their risk weighted assets then 7% may actually be 7% of say 30% of total assets or 2.1%. Beliefs are difficult to regulate and as desirable as it may be to prevent future issues, the most realistic route is to dampen the impact of these issues. A 10% tangible equity capital ratio would do just that, but my faith does not lie with an overly complicated risk weighted system which I fear may still leave banks vastly undercapitalised for the next crisis.

The UK in Europe: the problematic team member

I think it’s pretty safe to say that in the UK, we’re notoriously Eurosceptic, and you just have to open some of the UK’s bestselling papers such as the Sun or the Daily Mail to find some article which will invoke dislike of Europe. In a Eurobarometer survey (2012), 14% more UK citizens said the EU conjured up negative images compared to positive. Interestingly for the EU as a whole, the results were very different, with the EU having a positive image for 17% more people than a negative image. Perhaps our scepticism comes from our indifference; 63% of UK citizens don’t know any European Institutions compared to 33% for the rest of Europe. We just don’t take an interest in European politics (even though it’s estimated 15.5% of our legislation comes from Europe). Turnout in the MEP elections in 2009 was 34.7% for the UK although for the rest of Europe this figure wasn’t much higher. What I was shocked to find out, excuse my ignorance, is that the UK in the European Parliament represents about 10% of the seats, the same amount as France and Italy and not trailing too far behind Germany. In other words, from a country perspective we currently have the potential to be a heavyweight! But if you look at the European Parliament map, we’re nobodies. 13 MEPS joined the socialists (representing 7% of the largest centre left group), 11 joined the liberals, 5 joined the greens and none joined the EPP, the largest centre right party (and the largest party in the parliament) even though the UK elected 43 centre right MEPS! These 43 didn’t join any of the main European parliamentary parties, effectively going alone. If these 43 had joined EPP this would represent 14% of the new total, a considerable amount.

Thanks to BBC interactive election map

The UK has so much to offer Europe and instead our MEPs sit on the side-lines hoping somehow that if we don’t get involved it will go away; wrong. When we don’t get involved, Europe develops, simply without us. If the UK doesn’t share the same aspirations and federal dreams of Europe, can we force it to? A YouGov poll (Oct 2012) states that in a referendum on Europe, 32% of UK citizens would vote to remain and 48% would vote to leave; in other words 50% more people support leaving. But from an economic and social perspective would we actually be better off? Academic studies, articles and blogs are divided as to the costs and benefits of leaving and I think this division highlights how nobody really knows. What we do know is countries like Norway benefit nicely (in a UK perspective) from being part of the Europe Free Trade Association (EFTA) and European Economic Area (EEA) with free movement of goods, services, capital and persons. They are not, however, bound by policies such as CAP and justice and home affairs. I think, whatever your stance on the EU, we have to acknowledge that as a country, we simply are not committed to the European project.

The EU referendum vote (picture courtesy of the Economist) 

I think the current arrangement is simply causing a lot of resentment both at home and abroad. An article by the BBC reveals how certain European counterparts take a stance of “goodbye and good riddance” when it comes to the UK leaving. I think the UKs relationship with Europe is unhealthy at present and just as the SNP want an amicable “divorce” from Westminster, perhaps we should be doing the same with Europe. The UK does not need to leave on bad terms, but we should wake up to the fact that our heart is not in it. My worry is that if we don’t either start cooperating or decide to renegotiate, the marriage will deteriorate further, our voice will be lost, and the divorce could be nasty. If your heart is not in playing a team sport, you’re probably going to moan, play badly and irritate a lot of your team mates. This is no way to participate. Eurosceptic attitudes in the UK are rife, our ignorance is shocking and European politics simply do not interest most of us. Let’s face it; we’re not team players in Europe! This is only to our detriment; if we side line ourselves, the “team” will appear to dictate to us and we can feel trapped. We are in a lose, lose situation. It’s time we participated or renegotiated. Public support does not seem to be for participation so I don’t see a choice but to renegotiate our positioning in the EU. It will be a gamble of course, but I think our European counterparts will respect our decision. And one day, perhaps we can become a full member again, but on that day, we need to fully embrace Europe and just as a person from Ohio calls themselves American, we will need to be proud to call ourselves European.

Credit rating agencies: The infallible church of the financial world

The role the credit rating agencies played in the financial crisis is significant if not extreme. After all, it was their “blessing” which turned junk into gold. In many respects the rating agencies are like the medieval church; their power stemming from their greatest advantage: belief. When it comes to most things in life, especially where we lack knowledge, such as going to the doctor, we have to put our faith in someone else. But what happens if we place our faith in the wrong hands? A paper by Benmelech and Dlugosz (2009) highlights some of the failings of the credit rating agencies.  In 2007 and 2008, approximately 7% of structured finance securities rated by Moody’s were downgraded each year and the average downgrade was around 5 notches. Structured financed securities that fell 8 or more notches were most likely to be rated AAA (the fallen angels) and almost two thirds of downgrades were attributed to securities backed by home equity loans or first mortgages. Now while 7% may not seem an excessive amount, we have to bear in mind that this is the equivalent of 7% of Rolex watches turning out to be market stall fakes; it’s not good enough.

Backed by belief?
(Picture courtesy of compellingparade.com)

It was the AAA ratings which allowed the securitisation machine to go into overload, eventually leading to massive write downs. The credit rating agencies were trusted and they failed; their stamp of approval was adhered to even when similarly rated corporate bonds were paying much lower interest. Moody’s had the expected default frequency (default probability) of Lehman brothers 3 months before it went bust at 0.6%; what a prediction! So why do investors put their faith in this holy trinity of institutions? Over the years they have obtained the force of law (see White (2009)), with safety judgments outsourced by regulators and significant barriers to entry created by the SEC. They are an opaque ruling elite; incompetent, complacent and corrupt. The issuer pays model is subject to extreme abuse and the money generated by the credit rating agencies in the run up to the crisis was enough to allow corners to be cut and concerns to be overlooked. They have gone from caring about accuracy to caring about profits; the money is just too easy. 

AAA it is then....
(Picture courtesy of healthimaging.com)

I keep thinking of ways to transform the credit rating agencies but then I realise what is needed is not necessarily tonnes of rules and regulations but simply a change in attitude, both by investors and by the state. These credit rating agencies after all are only providing “opinions” (their words!) The reliance on the ratings, such as advocated by Basel iii, needs to be scrapped; the state and the church need to be separated. Investors putting their absolute faith in the opinion of credit rating agencies is like putting all your faith in a slick car garage salesman; you’ve got to be a bit more savvy than that! Yet, despite all their mistakes, the Big Three still hold about 95% of the market share. Issuers need to seek new rating agencies (more reliable ones) and investors need to start recognising these other rating agencies, otherwise more accurate and innovate agencies are simply being overlooked. In general, more scepticism needs to be shown. The Big 3 rating agencies have shown their weakness and while governments may impose tighter regulation and new rules, the spirit of change lies with the investor. The church should be run by its people, not the other way round!