This is one of those posts where the logic is more important than the facts assumed because, if those specific facts are wrong, the logic still holds for a large number of actual situations.
Basel II is the second of the Basel Accords, which are recommendations on banking laws and regulations issued by the Basel Committee on Banking Supervision. I wasn’t there, and I haven’t studied the workings of the conference, but here’s the logic that seems to have led to the conclusion that was reached:
1. Banks that lend to good risks need less capital than banks that lend to bad ones.
2. Under current standards, the amount of capital required does not adequately reflect the relative safety of the loans being made, i.e., too much capital is being required for very safe loans.
3. With the growth in imbalanced international trade (think oil and China), the financial system has an ever-increasing need to convert surplus countries’ reserves into deficit countries’ capital.
4. If capital standards are reduced for highly-rated loans, more money can be repatriated.
5. Therefore, banking standards should allow significantly higher leverage for highly-rated loans.
The flaw in this logic is the unstated assumption that premises 1 and 2 are independent, that the safety observed for highly-rated loans is independent of the rules limiting their amount. I believe that implementing the conclusion – reducing the capital required for highly-rated loans – actually caused the safety of such loans to suffer. As the folks in the philosophy biz might say, making the descriptive prescriptive has made the description false.
The weakest link in the financing chain holding up Basel II is the ratings system. Highly-rated loans are safer than non-highly-rated loans for one simple reason: they deserve to be highly rated. They are not less risky because they are highly rated; they are highly rated because they are less risky. So, if something changes in the financial system so that ratings are no longer reliable, capital standards based on ratings become dangerous.
What can cause the ratings system to become unreliable? How about an exponential rate of increase in the demand for highly-rated paper? That demand creates a demand for investment bankers to spin Baa straw into AAA gold, and investment bankers, in case you haven’t noticed, have lots of money to spend to make the lots of money they make. The demand for highly-rated paper after Basel II was unprecedented, and the pressure on the ratings agencies to polish turds became overpowering. This is not to excuse the raters. To the contrary, I see them as the biggest culprits in the whole mess, the people with the last clear chance to stop the madness. But their fallibility still needed to be reckoned with in the human engineering of Basel II.
Of course, blaming the whole thing on our trade deficit as I do, I see Basel II as just another inevitable consequence of too many dollars needing to come home and us having to take them in. The bandwidth of the financial system had to be increased, and increased bank leverage does provide increased financial bandwidth. The alternative to more leverage would have been more capital. Foreign-held reserves would have to be used to capitalize new or existing banks, something that the owners would have resisted. It’s hard to imagine the political will to reach that result absent a crisis, so Basel II seems like the natural domino to fall once the trade deficit ballooned. Now that we’ve had the crisis, if capital levels are restricted, capital infusions will follow. Goldman, Sachs, & Al-Waleed Sinobank. Ick.
But I digress. Today’s moral is simply that you cannot codify an observation and expect that the observation will not change. Much of our regulations make this mistake. We should be on the look-out for examples in the big policy prescriptions coming along in healthcare, energy, and financial services.
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No sooner did I complete this post than I read an article in the New York Times about how the ratings agencies dislosed their ratings models, and investment bankers used those models to qualify for ratings that were not deserved. That's possible because ratings models assume that certain criteria are met as a result of a loan's underlying structure and not because the loan is designed from the outset to satisfy those criteria. Think of it as teaching to the test.
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