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.
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| 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.
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| 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.
