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.