Why Capital Standard Regulations Will Fail (Part 2)

In my earlier post, I presented one of the three major arguments on why capital regulation standards won’t live up on its expected role to curb systemic failures.

regulators think that the action of bankers can be restrained by virtue of fiat. They are delusional. They forget that as humans, regulator-banker relationship will be subject to various conflict of interests relationships such as the agency problems, time consistency dilemma, regulatory arbitrage and regulatory capture aspects.

In reality, more politicization of the banking-central banking amplifies systemic fragility.

In a recent paper Cato’s Kevin Dowd, Martin Hutchinson, Simon Ashby, and Jimi M. Hinchliffe writes, (bold emphasis mine)

In this paper, we provide a reassessment of the Basel regime and focus on its most ambitious feature: the principle of “risk-based regulation.” The Basel system suffers from three fundamental weaknesses: first, financial risk modeling provides the flimsiest basis for any system of regulatory capital requirements. The second weakness consists of the incentives it creates for regulatory arbitrage. The third weakness is regulatory capture.

The Basel regime is powerless against the endemic incentives to excessive risk taking that permeate the modern financial system, particularly those associated with government-subsidized risk taking. The financial system can be fixed, but it requires radical reform, including the abolition of central banking and deposit insurance, the repudiation of “too big to fail,” and reforms to extend the personal liability of key decision makers—in effect, reverting back to
a system similar to that which existed a century ago.

The Basel system provides a textbook example of the dangers of regulatory empire building and regulatory capture, and the underlying problem it addresses—how to strengthen the banking system—can only be solved by restoring appropriate incentives for those involved.

So the Cato study essentially echoes my insights.

For me, ‘regulatory empire building’ signifies as the conventional political process that has been designed to promote and sustain a welfare-warfare state. The welfare-warfare state depends on the de facto fiat paper money platform that basically operates on a central banking-banking industry cartel, which funnels much of the funds from the private sector to the political class (financial repression).

The Basel system essentially institutionalizes such operating framework. Capital standard regulations applied to the global banking system which assigns government bonds as ‘risk free’, which requires banks to finance government spending by holding sovereign liabilities into their balance sheets, has been backfiring on the back of unsustainable economics of the welfare-warfare state. Economics cannot be dictated by fiat or by legislation.

The financial system can indeed be fixed, but I think, it will take a a major systemic collapse for the political incentives to change.

In the meantime, politicians around the world will invariably resort to various band-aid, kool aid and ‘extend and pretend’ measures in response to any emergent problems. This will continue to accrue strains into the fragile incumbent operating system.

Let me repeat, politicization of the banking and financial industry will amplify, and not reduce, systemic fragility.

Genuine reforms must be directed towards empowering the markets over politics.