Streetwise Professor

September 15, 2010

More Guests Check Into (Basel) Faulty Towers

Filed under: Derivatives,Economics,Financial crisis,Politics — The Professor @ 3:35 pm

Felix Salmon is a big fan of Basel III, but admits to concerns about the perpetuation of the Basel II risk weightings after reading this by Noah Millman in the Economist:

More important, the new regulatory scheme could fail in several ways. The most serious failure in Basel III is that it doesn’t address the principal contribution of Basel II to the last financial crisis, namely, the calculation of risk-weights. One of the key components of Basel II was to increase the amount of capital banks had to hold against riskier assets. Extremely low-risk assets, meanwhile, could be held with very little or even no capital. Risk, moreover, was calculated primarily by reference to the rating assigned by one of the recognised ratings agencies. The consequence of this Basel II reform was to discourage banks from lending to risky enterprises, and to encourage the accumulation of apparently risk-free assets. This was a primary contributor to the structured finance craze, as securitisation was a way to “manufacture” apparently risk-free assets out of risky pools. What brought banks like Citigroup and Bank of America to their knees wasn’t direct exposure to sub-prime loans, but exposure to triple-A-rated debt backed by pools of such loans, debt which turned out not to be risk-free at all.

Since it did not change this risk-weighting, Basel III effectively doubles down on Basel II.

Martin Wolf at the FT echoes these concerns, even more forcefully:

These new ratios are also very much the children of Basel II, the previous regulatory regime: they rely on what should by now be discredited risk-weightings – one of the points Martin Hellwig of Germany’s Max Planck Institute makes in a superb recent paper on the intellectual bankruptcy of current approaches to regulation of capital. We might think of the new requirements as a “capital inadequacy ratio”.

The Hellwig paper is worth a read.

Needless to say, I agree with these concerns about Basel III.  It’s better than Basel II because it has higher capital levels (even though Wolf thinks they are grossly inadequate), but it shares the fundamental flaw: the attempt to price risks, which is doomed to failure because those setting the prices are going to have less information than those responding to them, who can moreover design their portfolios and design securities and financial instruments to exploit mispricing of risks.

I wrote about this several times, most recently in Basel Faulty.

Yes, there is a bigger cushion in Basel III, and the liquidity requirement is an improvement.  But Basel III perpetuates the most problematic feature of Basel II.  In particular, I think it bears repeating that since the mispricing will distort the incentives of all covered entities, it tends to lead them to trade the same way, which is lethal in response to a systemic shock.

It is nice to see that this is becoming increasingly recognized, but it is discouraging that the message does not appear to be coming through loud and clear–or even garbled–where it matters, in Basel.

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