Why the Greek Debt Panic?

The key to understanding the “Basel thesis” about the cause of the crisis, advanced in Critical Review’s special issue on the crisis by coauthors Viral Acharya & Matthew Richardson, and by coauthors Juliusz Jablecki & Mateusz Machaj, as well as by Wladimir Kraus and me in our forthcoming Engineering the Perfect Storm: Banking Regulation, Capitalism, and Systemic Risk (University of Pennsylvania Press, 2010), is to understand one thing: The bursting of the housing asset bubble would not, alone, have caused (1) a financial crisis, and thus probably would not have caused (2) a worldwide recession of such depth.

This is also a point made by the other coauthor team in Critical Review’s special issue, Steven Gjerstad and Nobel laureate Vernon L. Smith. Asset bubbles pop all the time, but worldwide financial crises are rare.

A financial crisis is a banking crisis. So why did the bursting of the asset bubble in housing cause a banking crisis, freezing interbank lending and then bank lending into the “real” economy?

Because, according to the Basel thesis, Basel I bank-capital regulations, enhanced in 2001 in the United States by the Recourse Rule, encouraged banks worldwide and especially in the United States to leverage into asset-backed securities, including mortgage-backed securities, that were either government guaranteed (by Fan or Fred) or were privately issued but had an AA or AAA rating. How did the Basel rules encourage this? By giving such securities a 20 percent risk weight.

Translation: An AAA-rated mortgage backed security worth $100 required only $2 in bank capital at the 8 percent Basel rate for adequately capitalized banks. $100 x .08 x .20 (the 20 percent risk weight assigned to asset-backed securities by the Recourse Rule) = $2. By contrast, a commercial loan of $100 required $8 of bank capital, because Basel gave such loans a 100 percent risk weight. $100 x 8 percent x 1.00 = $8. Similarly, a $100 whole mortgage retained by the bank required $4 of capital, because the Basel risk weight for unsecuritized mortgages was 50 percent. With these risk weightings, securitized mortgage-backed debt offered significant capital relief.

Today’s FT brings the news that “European financial institutions have $235 billion worth of claims on Greek debt, most of which is thought to be in government bonds.” Why do they hold so much Greek government debt? Because under Basel II, implemented (outside the United States) in 2007, Greek government bonds, rated A-, had the same 20 percent risk weight as AA/AAA asset-backed securities in the United States. That is, until S&P downgraded Greek debt from A- to BBB+. That raised the risk weight to 50 percent, suddenly requiring 60 percent more capital from banks holding Greek bonds.

This appears to be the reason that the possibility of Greek default has led to fears of another banking crisis.

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About Jeffrey Friedman 4 Articles

Affiliation: University of Texas, Austin

Jeffrey Friedman is a political scientist and the editor of Critical Review: An Interdisciplinary Journal of Politics and Society.

Friedman graduated from Brown University in 1983 with a double major in History and Philosophy, and received an MA in History at the University of California, Berkeley, in 1985 and a Ph.D. in Political Science from Yale in 2002. He taught in the Government department at Dartmouth College in 1998, the Social Studies program at Harvard from 1998 to 2000, and the Political Science department at Barnard College, Columbia University from 2001 to 2006.

In 2006 he resigned from the Barnard faculty to edit Critical Review, which he had founded in 1986. The initial purpose of the journal was to bring critical scrutiny to bear on libertarian scholarship, and to subject mainstream scholarship to similar scrutiny. As part of this effort, Friedman published an article, "What's Wrong with Libertarianism," that prompted wide discussion among libertarian writers. Since then, the journal has evolved into a scholarly forum for critically assessing the realities of democracy and capitalism, emphasizing the actual functioning of democracy in the light of political scientists' findings of "public ignorance" of political affairs, and related questions such as electoral "mandates," media bias, academic bias, and the autonomy of state officials from public scrutiny. Friedman's articles "Public Opinion and Democratic Theory" (1998), "Public Opinion: Bringing the Media Back In" (2003), and "Popper, Weber, and Hayek: The Epistemology and Politics of Ignorance" (2005) addressed these issues.

Friedman is a visiting scholar in the Government Department of the University of Texas at Austin, and the Max Weber Fellow of the Institute for the Advancement of the Social Sciences at Boston University.

Visit: Critical Review, Causes of the Crisis

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