Prescient, and a Reminder

While doing her research at Heritage, Renee came across this 2000 article in Regulation by Thomas Oatley. It discusses the Basel capital standards, and is amazingly prescient:

Faced with this simple risk classification scheme, banks altered their lending behavior in ways that  regulators did not expect. For example, the risk classification provides incentive for banks to hold riskier loan portfolios than they would have held otherwise. Because the regulations assign the same risk  weighting and capital costs to all loans within a given category, banks have incentive to shift toward higher-risk, higher-interest assets within each category. For example, a loan to a triple-A rated corporation receives the same risk weighting as a loan to a heavily indebted start-up firm, even though the loan to the start-up has a much higher probability of default. Because the banks charge higher interest to the start-up, they are more inclined to make that loan than to lend money at a lower interest rate to the secure corporation.

The risk classification scheme also offers incentive for banks to engage in regulatory capital arbitrage. When capital requirements are not based on a standard like the probability of insolvency, banks can often restructure their portfolios in order to reduce their regulatory capital requirements without reducing their risk. By securitizing assets, banks can unbundle and repackage risks to transform on-balance sheet assets into off-balance sheet assets that fall into lower risk weight categories. While reliable information on the scale of regulatory capital arbitrage is not available, the Federal Reserve has estimated that securities used to engage in regulatory capital arbitrage account for more than 25 percent of total assets of the United States’ ten largest banks. In several individual cases, those securities account for close to 50 percent of total assets.

The problems created by regulatory capital arbitrage pertain less to the off-balance sheet assets and more to the on balance sheet assets. Banks can only securitize high quality assets at acceptable cost; thus, regulatory capital arbitrage moves higher quality assets off banks’ balance sheets in operations referred to as “cherry picking.” This causes the average credit quality of banks’ on-balance sheet assets to deteriorate as high quality assets disappear and low quality assets remain. Against this lower-quality  balance sheet, the Basle Accord’s eight percent capital requirement may be insufficient and banks’ capital ratios may provide a misleading measure of banks’ true financial condition. Because market participants use capital ratios to determine the health of lending institutions, the weakened quality of this information may harm market discipline. [Emphasis added.]

That is an eerily accurate description of a process that accelerated in the 2000s, and culminated in the Financial Crisis.  Whether it was AAA CDOs or Greek government debt, banks loaded up on investments that received highly favorable capital treatment under Basel.  And it was those things that blew up the banks–and could blow them up again.

Ironically, Basel was intended to increase the rigor of capital regulation to make banks safer.  But as I’ve written repeatedly over the past year, capital requirements essentially impose price controls.  In this instance, the prices relate to risk.  But the price controls underprice some risks, and those are the ones that attract financial institutions like moths to the flame.

Enhanced capital requirements are again being touted as a way of preventing the next crisis.  But the Basel Rules were a response to a crisis–the Latin American debt crisis–that paved the way for the next one.

If the incentive system encourages financial institutions to take on tail risks (due, for instance, for implicit government guarantees), those institutions will find the vulnerabilities in the capital requirements through which they can smuggle such risks onto their balance sheets, like hackers identifying and exploiting each new vulnerability in Windows.

The existence of vulnerabilities is inevitable–no centrally created set of risk prices will be even close to right.  Which means that enhanced capital requirements provide a false sense of security.

The problem is that the ability of the institution that can price risks more accurately–the capital markets–is fatally undermined by the very real prospect of bailouts of institutions that fail.  That is the Original Sin, and as long as we remain in that fallen state, a future crisis is almost inevitable, capital requirements or no.  Indeed, the main effect of capital requirements as implemented will be to determine exactly what causes the crisis, not the likelihood of its occurrence.

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