Basel

Wall Street Wrecked The Economy, Not Big Government

Zach Carter — Tue, 21 Sep 2010 10:02:18 -0400

Over at bloggingheads, my CAF colleague Bill Scher discusses the new international banking standards with Conn Carroll, a conservative blogger for The Heritage Foundation. Carroll actually agrees with a lot of what I have to say about Basel III, but I he draws conclusions from my post that overemphasize the role of regulation and ignore the insane lobbying and outright fraud that Wall Street deployed to create a crisis.

The fact that Carroll and I can agree on this stuff (to an extent) shouldn't come as a terrible shock—Wall Street reform is about the basic functioning of the economy—it's not an issue that needs to ignite ideological conflict. Here are his key comments:

"I like the acknowledgement that the problem of this last financial crisis had to do with a problem of regulation."

Nothing wrong there. You'd have to be insane to believe that financial regulations—or the regulators who implemented them—were up to snuff. But here's where I part ways with Carroll:

"When this economy started melting down and the financial crisis happened . . . the reason is regulation. It wasn't because of the free market, it was because of Basel II with their regulations saying that AAA-securities were an asset that qualified created a huge demand for all of these mortgage-backed securities."

Basel II was indeed terrible, and the credit rating agencies were totally corrupt (quite possibly fraudulent) operations. But you can't blame Basel II and the rating agencies for all of the Wall Street excess that created the crisis. Basel II didn't force banks to buy up lousy mortgage-backed securities that rating agencies had evaluated improperly. Nobody required banks to rely on bad ratings alone. Bankers and traders were paid very well to find assets that would enrich their firms. They got it completely wrong, destroyed their companies and nearly destroyed the global economy. The fact that rating agencies also got it completely wrong doesn't excuse this behavior, nor does the fact that regulators also relied on rating agencies. Bankers found loopholes, exploited them and wrecked the economy.

In other words, the financial crisis is a story about regulation allowing reckless behavior, not a story about regulation encouraging reckless behavior. Bad regulations let the free market to run amok—they did not tie the market's hands and require market actors to do reckless things they really didn't want to do.

Plenty of people at major Wall Street banks knew that they were courting disaster, but went ahead in the quest for bigger bonuses. Everybody on Wall Street who packaged mortgage-backed securities and collateralized debt obligations knew the rating agencies were meaningless, because they had to work with those same rating agencies in concocting their own toxic securities.

What's more, plenty of people on Wall Street knowingly bought the toxic securities that they themselves created. ProPublica has documented the most damning case of this practice, a situation in which banks sold crappy CDOs to investors, but actually purchased risky parts of the CDO themselves in order to establish fake demand for the entire product. Merrill Lynch was the most frequent offender in this respect, but Citigroup and Goldman Sachs adopted the same scheme.

Rating agencies and Basel II didn't force Goldman to concoct a "shitty deals" and brag about them over email, and they didn't force Lehman Brothers or Bank of America to adopt Enron-style schemes to conceal debt from investors.

The lousy financial regulations that lead up to the crisis were not written by wild-eyed consumer advocates unaware of the potential consequences. They were written by policymakers who were extremely sympathetic to the global financial elite, and in many cases, by policymakers who were members of the global financial elite. They knew these rules wouldn't do much to affect banker behavior, which is why they pursued them.

That point applies to just about every faulty regulatory maneuver preceding the crisis. In the U.S. alone, policymakers lifted leverage caps on Wall Street investment banks, deregulated the derivatives market, repealed Glass-Steagall and refused to regulate the mortgage market. That was because regulators had been corrupted by the financial establishment, not because it's just impossible for regulators to figure out how to write decent financial rules.

None of this, of course, implies that international regulators should continue to rely on rating agencies or exclusively rely on any risk-weighted capital requirements. On this, Carroll and I agree. Whatever the criteria for risk-weighting, Wall Street will come up with some way to game those rules. When they do, we'll all wish Basel III had imposed a meaningful, hard leverage cap as a back-up.

Basel III Is Still Bonkers

Zach Carter — Wed, 15 Sep 2010 13:23:01 -0400

It's been two days, and the new Basel III bank regulations are still lousy. Martin Wolf slams the international banking accord here and Yves Smith agrees here, although Felix Salmon notes some improvements over the current banking regime here and Tim Fernholz offers a full-throated cheer for the new rules here.

What makes the new rules so unnerving? Martin Wolf nails it. First, as I emphasized on Monday, he says that the only real line of defense Basel III deploys involves risk-weighted capital, and risk-weighting can be gamed. More importantly, the new capital requirements just aren't anywhere near the levels needed to rein in banks that know they have access to unlimited government support. We haven't fixed too-big-to-fail, the banks know it, and as a result, we'll need much, much higher levels of capital than Basel III actually demands.

How much more capital? Wolf says 20 percent to 30 percent, without risk-weightings. What does Basel III actually deliver? A paltry 3 percent. As I noted on Monday, that's equivalent to a leverage ratio of 33-to-1, actually higher than the 31-to-1 leverage Lehman Brothers deployed at the peak of its crisis-era excess.

What's worse, this hard leverage cap is only a test. In a few years, the Basel committee will reconvene to determine whether such measures are even necessary. I can foresee only two possible outcomes. First, the global economy has suffered another major financial calamity and all will agree that the cap must be higher—this should be unacceptable. In the second, the economy is improving, the banks are making lots of money, and regulators agree that silly things like leverage caps are a relic of the past, an overreaction to a crisis that the world has moved on from, nevermind the millions of jobs lost and careers ruined in the process. Nobody is going to suggest moving the cap to 5 percent, much less 20. Catastrophe quickly ensues.

Felix Salmon acknowledges that the risk-weighting issue remains problem, but still sees reason to be "unapologetically happy and optimistic." Whatever it's flaws, Basel III is still better than what we've got now—this is unquestionably true, by the way—and besides, Basel III also features new liquidity rules, which will help keep catastrophes like Lehman from developing, so things aren't really that bad. Basel II included no liquidity constraints, which was certainly a mistake.

This is the general consensus on Lehman's collapse, but it's not really accurate. Lehman did experience a massive run immediately before its failure, but the Federal Reserve had already given the bank access to its discount window. The whole purpose of the discount window was to provide liquidity in the face of a bank run. But the Fed didn't lend to Lehman, because Lehman didn't have the collateral to support such a loan. In other words, Lehman wasn't just shy on liquidity, it was insolvent.

Moreover, there's a reason why investors pulled the plug on Lehman in the first place. The bank was totally overleveraged, and had invested in absolute garbage. Lehman knew it was overleveraged, and knew that the market was concerned, which is why it resorted to a complicated derivatives scam of dubious legality in order to hide a mountain of debt from its investors.

Sure, tighter liquidity rules are better than no liquidity rules at all. But without major capital requirements, banks are going to be prone to massive runs, and when the market reaches its verdict on a bank's viability, all the liquidity in the world won't stop the run. When Bear Stearns went down, investors wouldn't even accept U.S. Treasury bonds as collateral. No regulatory measures can overcome such a panic.

The key is to prevent the panic in the first place, and make sure that the consequences of the panic do not overwhelm the broader economy. At an absolute minimum, that means stringent capital requirements. Tim Fernholz thinks Basel III delivers the goods, calling the accord "a tough new international regime" and "a rare sign of optimism in the battle with the banks."

I just can't understand that view. My point is not that Basel III is worthless—it's very clearly a step in the right direction. But this is the structural response to the worst financial crisis in history. Given that backdrop, Basel III is laughably weak.

This was not the savings and loan crisis. Every major U.S. bank other than Lehman Brothers had to be bailed out on a massive scale, and bank bailouts in Europe sparked a string of sovereign debt crises that almost toppled the Euro. As a result of this enormous economic catastrophe, international regulators plan to bump up risk-weighted capital minimums from 4 percent to 7 percent (Basel II was 2 percent, but the U.S. implemented 4 percent) and acknowledge that liquidity can sometimes be a problem. This is akin to a doctor telling an alcoholic to keep drinking, but start taking vitamins. After he's suffered a heart attack.

Salmon says that critics who demand that Basel III prevent the next crisis are asking too much. Whatever the regulatory regime, he says, financial crisis are always possible. It's true-- we cannot predict the unforeseeable. But this truth is also meaningless. We can take measures to ensure that whatever crisis may come is not a global economic disaster, we can ensure that the cost of cleaning it up is low, and we can ensure that the costs to the broader economy are contained. Basel III falls short on all three of these goals. What's worse, all three of them are attainable.

New Bank Regulations Would Bless Lehman's Risk-Taking

Zach Carter — Mon, 13 Sep 2010 16:56:15 -0400

International bank regulators have finally agreed to a new set of rules to rein in financial excess, and the reviews thus far are cautiously positive. But the new capital requirements announced today by the Basel III accord are not actually as sturdy as they seem. By relying on definitions that can be manipulated by Wall Street, regulators have agreed to standards that place an international seal of approval on Lehman Brothers-style risk-taking.

In every financial crisis in history, banks have ruined themselves by overleveraging. "Leveraging" means "borrowing money," and "overleveraging" means "borrowing too much money." The basic process has been repeated hundreds of times: banks borrow tons of money and use it to place bets in the capital markets. When those bets are good, high leverage dramatically amplifies bank profits—and bank bonuses. But when those bets are bad, high leverage creates enormous losses—and enormous bailouts.

There are dozens of different ways to define leverage, but the most difficult one for banks to manipulate is also the simplest and most common-sense: total assets to total equity. If you have a lot of assets and not much equity, it means you're borrowing a ton of money to finance your business. It's going to be very hard to pay back all that debt if your banking bets start going bad.

By 2007, the official leverage ratio that Lehman Brothers reported to the public was 31-to-1 (see page 29 of their 2007 annual report). Despite lots of new tables about risk-weighted assets and Tier 1 capital, the only hard new leverage rule we have from Basel is a straight cap at 33-to-1. The means the new standards would leave plenty of room for the crazy risk-taking that brought down Lehman Brothers.

So why are so many smart people (Mike Konczal, Felix Salmon, Ezra Klein) saying good things about Basel III? Well, the new Basel capital standards are indeed a step forward—but that says more about how pathetic the current capital standards are than about how great the new rules are. For years, regulators have used very lax definitions of what constitutes "capital" in calculating their capital ratios. They've also allowed banks to use lax definitions of what constitutes an "asset," and allowed the minimum ratios to be far too low.

Basel III improves on the old regime by strengthening the definition of "capital" and raising the bar for the ratios themselves. It does not do much about the definition of an "asset," however, which leaves the new standards open to abuse.

So while it's good to see minimum capital ratios increase from 4 percent to 7 percent, the reality is less exciting. Those percentages do not correspond to hard asset values, but rather to "risk-weighted" asset values. Right now, risk-weights are basically determined by ratings on various securities—ratings which proved fundamentally unreliable and potentially fraudulent over the past decade. Combined with the fact that banks themselves get to apply the risk-weightings to their assets, the new Basel III standards are subject to an obvious source of abuse, and will encourage new risks. Banks will apply inappropriate risk-weights in order to take on more leverage while technically conforming to the letter of the law, and they'll systematically seek out assets that have inappropriately low risk-weights in order to take on higher leverage, fueling asset bubbles in things like, say, subprime mortgage-backed securities.

Under the standards released last night, international regulators did agree that banks must hold equity equal to 3 percent of total assets. That's as hard as any leverage or capital standard can be, it's just completely inadequate. To reiterate: 31-to-1 leverage brought down Lehman Brothers, and Basel III will permit 33-to-1 leverage.

All capital standards, however rigorous and however well-defined, depend on honest accounting. If a bank insists that an asset is worth a lot of money when it's really a worthless pile of garbage, banks are able to book phantom profits instead of taking losses. That's exactly what happened as the crisis unfolded, with regulators bending over backwards to offer accounting leniency. One agency actively cooked the books for banks, while Congress browbeat the board who oversees accounting standards into letting banks make up their own asset values. That accounting "flexibility" is still in place today, with banks refusing to write down all kinds of mortgages, especially second-lien mortgages, which are borderline worthless once housing prices fall.

But these accounting absurdities aren't really a knock on Basel III—they're a problem inherent in any attempt to rein in banks by resorting to capital requirements alone. A hard, meaningful cap on leverage would be a dramatic improvement over what Basel III has produced. But still better would be a market in which banks were not so bloated that their failure could jeopardize the entire economy. We have to break-up the big Wall Street banks.

Yet U.S. policymakers have refused to go this route, and as a result, all of our financial stability eggs are in the Basel III basket. So while the new rules are a legitimate step forward, they're not up to the task that Congress and the Treasury Department have set for them. Basel III will not be enough to prevent another massive financial crisis in the near future.