I’ve explained on many occasions how the financial crisis was largely the result of government-imposed mistakes, and I’ve paid considerable attention to the role of easy money by the Federal Reserve and the perverse subsidies provided by Fannie Mae and Freddie Mac.
But I’ve only once touched on the role of the Basel regulations on capital standards.
So I’m delighted that the invaluable Peter Wallison just authored a column in the Wall Street Journal, in which he explains how regulators created systemic risk by replacing market forces with bureaucratic edicts.
Europe’s banks, like those in the U.S. and other developed countries, function under a global regulatory regime known as the Basel bank capital standards. …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 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. …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.
What’s amazing (or perhaps frustrating is a better word) is that the regulators didn’t learn from the financial crisis. They should have disbanded in shame, but instead they continued to impose bad rules on the world.
And now we find their fingerprints all over the sovereign debt crisis. Here’s more of Peter’s column.
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. …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.
This is not to excuse the reckless behavior of national politicians. It is their destructive spending policies that are leading both the United States and Europe in a race to fiscal collapse.
But banks wouldn’t be quite as likely to finance that wasteful spending if regulators didn’t put their thumbs on the scale.
It’s almost enough to make you think that regulation is a costly burden that hurts the economy.
[…] we have yet another case study (for others, see here, here, here, here, here, here, here, here, here, and here) of red tape being bad […]
[…] wasn’t the right answer. It wouldn’t make banks safer (since it would be based upon the deeply flawed Basel regulations), but could become a vehicle for nations such as Germany to further subsidize countries such as […]
[…] The strongest example for my position is what happened with the “Basel” banking rules. International regulators were the ones who pressured financial institutions to invest in both mortgage-backed securities and government bonds. […]
[…] wasn’t the right answer. It wouldn’t make banks safer (since it would be based upon the deeply flawed Basel regulations), but could become a vehicle for nations such as Germany to further subsidize countries such as […]
[…] wasn’t the right answer. It wouldn’t make banks safer (since it would be based upon the deeply flawed Basel regulations), but could become a vehicle for nations such as Germany to further subsidize countries such as […]
[…] wasn’t the right answer. It wouldn’t make banks safer (since it would be based upon the deeply flawed Basel regulations), but could become a vehicle for nations such as Germany to further subsidize countries such as […]
[…] that’s just part of the story. The regulatory cartel also decided to provide a one-size-fits-all endorsement of government debt. Now we’re in the middle of a sovereign debt crisis, so we see how that’s turning […]
[…] won’t be surprised to learn, though, that these rules caused imprudent behavior. Indeed, one of the slides from my presentation in Brussels specifically highlighted the perverse […]
WOW! LOTS OF WRITNG=NOTHING
GREENSPAN CUT 6.5% TO 1% NTERSET RATE— INCREASED MONEY SUPPLY TWICE AS MUCH IN FIRST FIVE OF BUSH AS IN PRIOR TEN YEARS
PLENTY FREE MONEY COME AND GET IT
PRIVATE LENDERS CREATED TOXIC MORTGAGES.BIG BANKS. ENCOURAGED TOXIC MORTGAGES SELL TO BLIND INVESTORS.
TRIPLE A
F&F HAD NOTHING TO DO WITH IT. O.
THEY COULD NOT BUY MORTGAGES FROM BANKS WHO MADE FAR MORE PROFIT SELLING AS SECURITIES
F&F MORTGAGE MARKET DECLINED
BIG BANKS COULD NOT UNLOD THE TOXICS
F%F LIMITED TO $300,000 MORTGAGE CAP.
BUSH HELPED. INCREASED CAP TO $729,000
BANKS THEN UNLOADED TRIPLE XXX TO F&F
MORTGAGE CREATORS CREATED FRAUD
F&F DO NOT CREATE MORTGAGES
WHY DO YOU INTEND TO DECEIVE?????
How does a Bank work under FDIC insurance?
I create a Bank. I put down $1000 and then up to about 16 people in this blog can give me $1000 each – per bank regulations. They don’t care who I am or what I do with the money, they’re FDIC (i.e. current and future taxpayer) insured. What incentive do I have to be careful with the $17,000 I’m holding? I can go to Vegas and bet it on black on the roulette, around 48% probability of winning. If I win, I pay about $500 in interest to the “depositors” and keep the remaining $16,500. If I lose, I’ve lost only $1000, FDIC (taxpayers) bail out the 16 depositors. I play again creating another bank. Sooner or later with such asymmetric win/loose odds I win.
So the fix? Withdraw, or at least trim the insurance to depositors? So that I have to prove to them that I’ll make sensible use of their money? Like companies have to do to attract and retain shareholders?
No, of course not, because that would decrease the involvement of politicians and the bureaucrats that they employ using taxpayer money and would thus dilute the need for politicians and their power. Plus people are invariably attracted to simple collectivist solutions that seem to put them in control according to their simple narrative of the way the world works.
So the fix is,… well you guessed it: More regulation. I can still go on collecting money in my 16:1 Ponzi scheme but the people will appoint regulators to oversee my investment activities, so that I do not end up investing at the casino. Alas, the people live in a delusion. They and their bureaucrats have the power to regulate me, but they will never be able to close all the doors to risk I can come up with. After all, I do not manage to pull a two million dollar a year compensation by being stupid – many seek the lucrative post. The question is, do you, the people, want me to use my brain to create something in free markets, i.e. something of true value, something that you really want, … or do you want me to expend my brain primarily devising methods to fool your regulators, so that I can take advantage of the free FDIC insurance you have injected into the system? The decision is yours people and I’m sure that you will choose to maintain the Ponzi scheme and hope that you will someday regulate me 100%.
So, bottom line, what will happen (since fixing the root cause is out of the question)?
Well, reality will take over, and regulation will essentially squeeze banks into a smaller role in the economy. This is already happening and that is essentially why money through the banking system is already hard to come by.
The role of banks in finance will decrease, returns for depositors will decrease (depositors are not yet convinced that this is now more or less permanent) and people who save (yes, those elusive savers which delay gratification/compensation for services already rendered and who presumably are much needed) will thus naturally reorient themselves towards investment vehicles that do not carry FDIC insurance and institutions that are less regulated in general (because these are the institutions that can make money and provide returns). Either way FDIC insurance fades away – because well…guess what? There is no free lunch and eventually those who pay the seemingly free lunch figure it out – either rationally or empirically. Meanwhile, America’s entropy increases and with loss of American exceptionalism in the American voter psyche loss of exceptionalism in the economic sphere will inevitably ensure. The American lemming voter march to average worldwide prosperity levels is well on its way…
“…banks were required to hold 8% capital against corporate loans, 4% against mortgages and 1.6% against mortgage-backed securities.”
1. Indeed that was the risk order assigned to these assets by a consensus of illuminati – and the public that put those illuminati in office. Alas, apparently that proved a little wrong…
2. Meanwhile another consensus of illuminati — and again the public that put them in office — the city planners, adopted a European centrally planned growth model whereby restricting the supply of housing people typically want – i.e. single family houses – in areas where people want them (i.e. inside or next to areas of high economic activity) was the way to a happier more sustainable and environmentally proper way. Therefore they also applied coercion to prevent building of desirable housing in desirable areas. Predictably prices skyrocketed on those areas — e.g. California ended up with housing prices six times that of Texas.
3. Meanwhile another consensus of illuminati – and again a centralized-plan thirsty public — thought that individuals on average were not giving housing the priority it deserves in their lives and apparently with issue 2 above squeezing many people out of being able to afford homes it was time for yet another central plan. So this third croup of publicly appointed illuminati thought they should apply some centrally planned coercive pressure i.e. should take resources from other economic activities and put them into housing.
4. A fourth group of illuminati thought that some more comprehensive centrally planned coercion should be applied to trim compensation from savers and give it to spenders in an attempt to create economic growth now at the expense of future growth (since of course, savers would predictably say “fool me once.. fool me twice…I stop saving, or at least I stop saving in a way that you can redistribute my deferred compensation through monetary macroeconomic manipulation).
Private markets enter into distortions too. However they are much more flexible and many of the problems listed in 1,2,3,4 are likely to either not have flourished or have self-corrected long before the distortion reached crisis magnitude.
Fiscal collapse is the goal.