Rate Watch #772 Basel Accords. Time to Dump Them?
April 22, 2011
by Dick Lepre
dicklepre@rpm-mtg.com
www.loanmine.com
Analysis
There is much talk regarding higher commodity prices. Commodities are more expensive because they are priced in dollars and the dollar keeps weakening. In fact, the increase in equity prices may be regarded as a change in the exchange rate between the Apple, the Intel and the Google v. the dollar. The dollar is weakening because the Fed has been increasing monetary base per QE II. As Milton Friedman said, "Inflation is always and everywhere a monetary phenomenon, in the sense that it cannot occur without a more rapid increase in the quantity of money than in output." Yesterday the Department of Justice decided to investigate why gasoline prices are so high. I trust that they told Bernanke to not leave town.
The Fed's standard answer is that core inflation is what is important not overall. Agricultural prices go up and down because of weather caused supply abatements followed by bumper crops. Oil prices go up because of the enormous political uncertainty and insecurity in a part of the world which produces oil. The present situation is different. It is the Fed's increase in monetary base which is causing the dollar to lose value and commodities to become more expensive. The notion that we need to fear deflation was lame when it was first made as an excuse for QEII and it remains lame.
If the Fed were a regular old bank (which it is not) it would be leveraged 51-1. Its assets are $2.67 trillion and its capital is $52.58 billion. The concern is that interest rates are going to rise just as the Fed trims monetary base to restrain inflation. The Fed reduces monetary base by selling Treasuries and it may well be selling them at a loss. Cognizant of this, the Fed changed its own accounting rules back in January making any losses a liability to Treasury rather than a decrease in capital. If that happens and the Fed is disguising losses the Fed will have less support from Congress as Congress has another one of those "You did what?" hearings.
Basel and Regulations
As a consequence of the mortgage mess/great recession we had Dodd-Frank which has created a great deal of additional banking regulation. I have no idea what the long-term consequences of these regulations will be on banking, the mortgage business and the economy. Regulations are made by people who usually do not have enough awareness of the consequences.
On an international scale we have the Basel accords which regulate international banking. The Basel accords are essentially an international standard for any bank which wants to do business outside the borders of its native country. They appear to be a system for making sure that everyone is playing by the same rules regarding, for example, how assets are risk-weighted. Before Basel each nation had its own definition of how to calculate bank capital and what constituted adequate capitalization. There is a Basel I, a Basel II and a soon to be in effect Basel III. In the rest of this piece I am referring to Basel II when I say "Basel.". My criticism of Basel II also pertains to Basel III. The entity which manages the Basel accords is called the Bank for International Settlements more commonly known as BIS.
Basel II requires all well-capitalized banks which operate internationally to hold capital greater than of equal to 8% of their risk weighted assets. Different assets classes have different risk weights: commercial loans are 100% risk, whole mortgages are 50% risk, GSE mortgage backed securities are 20% risk and government debt is zero risk.
The country which was most affected by the original Basel accords was Japan. Japan was having a real estate bubble just before Basel took effect. The real estate bubble in Japan was much better disguised that it was here. Japanese banks simply made new loans to replace non-performing loans disguising the size of the non-performing portfolio. The fact that the Basel accords kicked in when they did may be part of what Japan has has a stagnant economy for 20 years.
The issue really is this: are we better off with one set of banking regulations for all countries or would economies be better off if each nation decides its own standard for risk weighting of asset classes and capital requirements.
Basel has some standards which make little sense to me. Commercial loans are, per Basel, 100% risk. I see a couple of things with that. Not all commercial loans have the same real risk. Worse yet, if Basel makes no distinction between risk for good or bad commercial loans then a bank might choose to lend money to a company with worse credit because it would get a higher interest. Also having commercial loans at 100% risk is a possible way to create an extended recession if banks stop lending money to businesses.
To me, the problem with Basel is that it is static. It does not recognize that mortgage debt is riskier when there is a real estate bubble. It does not allow a change in risk weight for commercial lending when that lending might be expansionary and per se risk abating. Worse yet, Basel was partially responsible for the mortgage mess because it incorrectly assumed that MBS were less risky than whole mortgages. Banks sold whole loans which they had made according to their own standards because Basel allowed them to hold MBS with 60% less capital. In effect, Basel more than doubled their losses because it did not allow that those MBS were crap. Banks were making PLMBS (Private Label Mortgage Backed Securities) and selling them to FNMA because FNMA could not generate as many bad loans as HUD demanded. Basel made the enormously incorrect assumption that the risk of MBS was static. Instead of mitigating risk, Basel encouraged it.
What happened with the mortgage mess was that despite the good intentions of Basel and the good intentions of HUD no one saw the possibility that the result of their well-intended regulation not only failed to prevent a problem but actually helped cause it.
The notion that mortgage securitization minimizes risk makes perfect sense from a theoretical point of view. The failure was that Basel made no accommodation for the disasters created by government mandated downgrading of the quality of GSE debt or Wall Street and the debt rating firms downgrading the quality other MBS. Basel makes the incorrect assumptions that risk is static. It is not. Basel is, in a sense, a set of regulations for regulators and it failed to recognize that regulators can be just as wrong as bankers. Both bankers and regulators made cognitive errors. The story being constantly told is that the mortgage mess was due entirely to greedy bankers. While some bank losses were greed induced most of them were due to ignorance rather than greed. Some bank losses resulted from cognitive errors made as banks and regulators made incorrect assumptions about MBS. Failure to realize that the problem is not just greedy bankers or dishonest loan agents minimizes the complexity of the problem. It is imperative that if we want to prevent another such mess we understand what happened.
Basel now has an additional incorrect assumption. Basel treats sovereign debt as zero risk. That may have been plausible before the Eurozone debt crisis. With Greece, Portugal, Italy and Spain all having debt issues requiring intervention, the zero risk rate assigned to sovereign debt per Basel is absurd. It sways banks to lend money to badly governed nations instead of lending it to companies and individuals who could use those loans to create economic activity. The fact that S&P could have questions the rating of U.S. Treasury debt this week shows just how bad the overall sovereign debt situation is. It is, to me, indefensible at present to suggest that all sovereign debt has no risk. Nations are rather dissimilar. Greece (the first to fall) is a nation with a history of political corruption.
In summary, Basel is built on a set of incorrect assumptions and we may be better off if we scrap the accords and have each nation let its central bank, the banks themselves and the legislated regulators work out what they believe is best for their nation. A competitive set of risks and rewards may be a lot better than the "one size fits none" mandate which result from Basel.
Dick Lepre
RPM - SF
1400 Van Ness Avenue
San Francisco, CA 94109
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California Department of Real Estate - real estate broker license #01201643
dicklepre@rpm-mtg.com
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