How Capital Regulations Contributed to the Current Crisis

At the Wall Street Journal, American Enterprise Institute’s Peter J. Wallison explains how capital regulations are partly responsible for the current mess (bold emphasis mine)

Basel is the Swiss city where the world's bank supervisors regularly meet to consider and establish these rules. Among other things, the rules define how capital should be calculated and how much capital internationally active banks are required to hold.

First decreed in 1988 and refined several times since then, the Basel rules require commercial banks to hold a specified amount of capital against certain kinds of assets. Under a voluntary agreement with the Securities and Exchange Commission, the largest U.S investment banks were also subject to the form of Basel capital rules that existed in 2008. Under these rules, banks and investment banks were required to hold 8% capital against corporate loans, 4% against mortgages and 1.6% against mortgage-backed securities. Capital is primarily equity, like common shares.

Although these rules are intended to match capital requirements with the risk associated with each of these asset types, the match is very rough. Thus, financial institutions subject to the rules had substantially lower capital requirements for holding mortgage-backed securities than for holding corporate debt, even though we now know that the risks of MBS were greater, in some cases, than loans to companies. In other words, the U.S. financial crisis was made substantially worse because banks and other financial institutions were encouraged by the Basel rules to hold the very assets—mortgage-backed securities—that collapsed in value when the U.S. housing bubble deflated in 2007.

Today's European crisis illustrates the problem even more dramatically. Under the Basel rules, sovereign debt—even the debt of countries with weak economies such as Greece and Italy—is accorded a zero risk-weight. Holding sovereign debt provides banks with interest-earning investments that do not require them to raise any additional capital.

Accordingly, when banks in Europe and elsewhere were pressured by supervisors to raise their capital positions, many chose to sell other assets and increase their commitments to sovereign debt, especially the debt of weak governments offering high yields. If one of those countries should now default, a common shock like what happened in the U.S. in 2008 could well follow. But this time the European banks will be the ones most affected.

In the U.S. and Europe, governments and bank supervisors are reluctant to acknowledge that their political decisions—such as mandating a zero risk-weight for all sovereign debt, or favoring mortgages and mortgage-backed securities over corporate debt—have created the conditions for common shocks.

I have explained here and here how Basel capital standard regulations does not address the root of the crisis—fiat money and central banking—and will continue to churn out rules premised on political goals, knee jerk responses to current predicaments (time inconsistent rules) and incomplete knowledge.

A manifestation of the institutional distortions as consequence to regulations which advances political goals can be noted at the last paragraph where US and European governments and bank supervisors are “reluctant to acknowledge that their political decisions”, which have not only “created conditions for common shocks”, but has existed to fund the welfare state and the priorities of political leaders in boosting homeownership ownership which benefited or rewarded the politically privileged banks immensely.

Capital regulation rules will continue to deal with the superficial problems of the banking system which implies that banking crises will continue to haunt us or won’t be going away anytime soon despite all model based capital ratio adjustments. It's been this way since the closing of the gold window or the Nixon shock (see above chart from the World Bank)

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.

US Federal Reserve Gambles With Untested Policy Tool: Paying Interest On Bank Reserves

Utilizing the “untested” policy tool of paying interest on bank reserves, the US Federal Reserve seems to be gambling away the US economy as well as the worlds’.

This Bloomberg article is a mouthful. (bold highlights mine)

Federal Reserve officials are staking their inflation-fighting credibility on an untested tool: the power to pay interest on bank reserves.

Congress granted the Fed this ability in 2008, and Chairman Ben S. Bernanke, Vice Chairman Janet Yellen and New York Fed President William Dudley have all cited it as a main reason why they’ll be able to keep the U.S. economy from overheating after pumping record amounts of cash into the financial system. Raising the rate, currently at 0.25 percent, is intended to entice banks to keep their money on deposit at the Fed instead of loaning it out and stoking inflation.

With the benchmark overnight lending rate trading at 0.1 percent, less than half the deposit rate, it isn’t clear how much control the central bank can exert over borrowing costs by raising the interest on reserves, said Dean Maki, chief U.S. economist at Barclays Capital. Internal critics also have cast doubt on the tool’s effectiveness. Philadelphia Fed President Charles Plosser said last month it isn’t a cure-all because it doesn’t address the need to shrink the central bank’s balance sheet and reduce the amount of reserves in the system.

“There is some concern in markets about whether the Fed will keep inflation under wraps as it goes through this exit strategy,” Maki said in a telephone interview from his New York office. “It’s unknown exactly what interest on reserves does to the economy.”

Cash in the banking system has ballooned since the credit crisis began in 2007, when the Fed embarked on its unprecedented monetary accommodation, which includes two bond-purchase programs that have swelled the central bank’s balance sheet to a record $2.69 trillion...

The amount of excess reserves climbed to $1.47 trillion this month from $991 billion at year-end and $2.2 billion at the start of 2007, Fed data show.

The Federal Open Market Committee begins a two-day meeting tomorrow and will decide whether to continue with its planned $600 billion of bond purchases through June.

The effectiveness of using interest on reserves, or IOR, as a main policy tool may depend on how closely the federal funds rate, or overnight inter-bank lending rate, follows its movements. The Fed has kept its target for the fed funds rate at zero to 0.25 percent since December 2008.

“The big unknown is how tight the spread between the IOR and effective fed funds rate will be,” said Dino Kos, a managing director at economic-research firm Hamiltonian Associates Ltd. in New York. “If the fed funds rate trades at a stable, and preferably narrow, discount to the IOR, then tightening policy through the IOR is doable. But a wide and unstable spread undermines the strategy.”

More...

The Fed probably would like to mimic the so-called corridor system in Europe, where the deposit rate acts as a floor to the overnight lending rate, according to Stephen Stanley, chief economist at Pierpont Securities LLC in Stamford, Connecticut. The U.K. central bank’s benchmark, now at 0.5 percent, is the rate it pays on the reserves it holds for commercial banks. That’s below the overnight sterling London interbank offered rate of 0.57 percent.

The Frankfurt-based European Central Bank pays a rate on the deposits banks park with it overnight. The ECB raised this rate a quarter point to 0.5 percent on April 7, the same day it increased its benchmark refinancing rate by the same margin to 1.25 percent...

Before the Fed boosts the deposit rate, it likely will use reverse repurchase agreements and its new Term-Deposit Facility to gain more control over the federal funds rate, Stanley said. He predicts the Fed will raise rates as soon as November, which he said is an “aggressive” time frame that reflects his concern inflation will accelerate.

In a reverse repo, the Fed lends securities for a set period, draining bank reserves from the financial system. At maturity, the securities are returned to the Fed, and the cash goes back to the primary dealers.

Stanley said he’s skeptical these transactions can operate at a scale big enough to suck sufficient cash from the system to control the federal funds rate. The rate fell as low as 0.08 percent on April 13 after the Federal Deposit Insurance Corp. began adjusting calculations of U.S. banks’ deposit-insurance fees this month to cover all liabilities instead of just domestic deposits.

Yet banks have been the major beneficiaries of this grand experiment via massive ‘risk-free’ subsidies.

From the same article...

The overnight lending rate has traded below the interest rate on reserves for almost two years, partly because Fannie Mae and Freddie Mac, the mortgage-finance companies under government control, became “significant sellers” of funds in the overnight market and aren’t eligible to place cash on deposit at the Fed, according to a December 2009 research paper by the New York regional reserve bank.

The “theory” of interest on reserves is “proved wrong every day: Why would a bank ever lend at less than what they’re earning at the Fed?” Maki said. “There are more issues here than it sometimes is made to sound. Chairman Bernanke mentioned the Fed could raise rates in 15 minutes if they decided to, but it’s not clear they have that kind of control on the funds rate.”

Where Ben Bernanke cheerfully says that “Paying interest on reserves should allow us to better control the federal funds rate”, this looks more like blind optimism than a verified method.

Economic Policy Journal’s Bob Wenzel says that the FED pays “EIGHT times equivalent market rates when they keep the funds as excess reserves” and that this rate is also “more than eight times the rate on one-month T-bills” which is almost like “gifting banks $890 million every three months”

And it’s of no doubt why the financial sector continues to outperform.

Chart from Bespoke Invest

Nevertheless the continued interventions via manipulation of interest rates, the policy of quantitative easings and all other forms of monetary tools including the experiment of paying interest on bank reserves are likely to give us more uncertain outcomes through heightened volatility (bubble cycles) which should translate to even more interventionism.