The Gnomes of Basel

by Jim Lacey
The banking system needs reform. But the Bank for International Settlements hasn’t a clue how.

Forget Zurich. When it comes to real power in the banking world all eyes focus on the small Swiss city of Basel, home of the Bank for International Settlements (BIS). The BIS was originally established in 1930 to help manage reparations payments imposed on Germany by the Treaty of Versailles following the First World War. That original purpose ended with the rise of the Nazis and their abrogation of the Versailles Treaty. But, like any good bureaucracy — whose top imperative is always survival — the BIS remade itself, first as the international manager for the Bretton Woods system, and later as an international banking regulator.

It is in this later incarnation that it has done the most damage. In its so-called Basel Capital Accords (Basel I), the BIS directed that banks keep capital reserves of approximately 8 percent, but then it risk-weighted those requirements. In doing so, the BIS noted that nations rarely disappear, and they are therefore usually available to pay their debts. In its infinite wisdom, the BIS declared that banks did not have to put any reserves aside to cover loans to sovereign nations. As far as the BIS was concerned, a serial defaulter such as Argentina was a better credit risk than IBM. Banks, which proved more than ready to put their reserves to work, piled into Latin America and other regions that, prior to the BIS ruling, they had treated with a great deal of circumspection.

When things eventually went bad, as they were sure to do, American banks, which had put aside only puny sums to meet such an eventuality, saw their capital erased almost overnight. Only through massive government intervention was the banking system brought back from the brink. Chastened, the BIS admitted it just was not very good at analyzing risks and setting capital requirements for large sophisticated banks. As the BIS saw it, the big banks would be much better at doing this for themselves. Basel II removed the BIS and national regulators from any role in determining capital requirements, on the assumption that banks, with their ability to do sophisticated risk modeling, would analyze their own portfolios and figure out how much capital they needed to put aside. The BIS was in the process of instituting these rules, with the full support of the U.S. Federal Reserve, when the 2008 banking crisis erupted.

Risk-modeling computers were supposed to create a nirvana in which clever bankers could monitor and adjust their risks and set reserves on a moment-to-moment basis. What everyone neglected is the historical record showing that models exist only so that one day they can be proven spectacularly wrong. Some bank models, for instance, placed the chances of the type of financial crisis that occurred in 2008 at 30 billion to 1. That is approximately twice as unlikely as a meteor smashing into your home, or 500 times as unlikely as your winning the Mega Millions lottery.

The fact that Basel II was such a spectacular failure even before it was fully implemented has not deterred Basel’s gnomes from working furiously on Basel III — third time’s the charm? The BIS is, in fact, almost ready to release the Basel III rules, which will probably set a minimum capital requirement of 7 percent for all banks, and add 2.5 to 3 percentage points on top of that for the 30 or so global banks judged to be “systematically important.”

How did they come up with these numbers? Well, the first thing you have to remember is that it has nothing to do with how much capital a bank may need to survive a crisis without government intervention. Rather, it is all the capital the BIS believes large European banks can raise right now, and even that is iffy for some banks. The real problem is that a 9 or 10 percent capital reserve is not going to be enough to see Europe’s largest banks through a default of one or more of the PIGS (Portugal, Ireland, Greece, Spain). One wonders if even 50 percent capital reserves would be enough to do the trick. Moreover, our own Federal Reserve believes that Basel III has not gone far enough. Federal Reserve governor Daniel K. Tarullo has stated that for systemically important financial institutions he would be more comfortable with a 14 percent capital reserve — about what Bankers Trust had on hand just prior to its being wiped out and acquired by Deutsche Bank in 1998.

The facts of life are that, if Greece defaults tomorrow, first the European banking system and then our own will start sprinting for the edge of the cliff. Bank capital reserves will vanish in a twinkling, and within weeks, days, or hours the global financial system will once again teeter on a precipice. Anyone putting his faith in Basel III is truly placing hope over experience.

So, what is the answer? Large American banks claim that adding to their capital requirements means less money will be available for lending. This is not a particularly good thing for an economy still trying to recover from a recession. There is little doubt that the banks are right about this, although some academics believe the problem can be alleviated by changing the capital structure of banks so that they give up their addiction to debt. As this would require major changes to the U.S. tax code, it is a debate for another day. In the meantime, we must recognize that without a reignition of credit formation there is little hope of a strong recovery.

Therefore, in the here and now, pragmatism must rule the day. Banks that are so systemically important that their failure can bring down the financial system need to maintain a high level of reserves — but not today. The banking system remains fragile, and until the United States has made a full recovery from the last recession it is not wise to do anything further to impede credit creation within the economy. Over time, and as the financial system repairs itself, there will be opportunities to reexamine bank reserves to ensure they are commensurate with the risks banks are taking, as well as the risk each bank presents to the financial system as a whole.

I am not sure, however, that the required decisions can be left to an international committee that typically creates a one-size-fits-all answer to any problem. I, for one, would prefer that banks with huge exposure to Greece be required to hold more reserves than banks that have avoided commitments to sovereign nations at risk of default. Moreover, we live in an era when banks can change their risk profiles in minutes. So whatever reserve rules we apply must be dynamic. A way must be found to measure the true risks represented by each bank’s loans, trades, and investments, and then change that bank’s reserve requirement as rapidly as it changes its risk profile. Finally, it is worth noting that no amount of capital is going to be enough to meet a global liquidity crisis of the sort that the meltdown of one or more Euro countries will present. There is no sense in disguising the fact that in a crisis an extra bit of capital cushion is just going to give us a bit more time for the government to ride to the rescue. Many banks really are too big to fail, and that is not going to change any time soon.

For at least the next few years, therefore, a 7 percent reserve requirement seems about right for American banks. That will give them the capital cushion required to get through most rough patches, while allowing them to expand credit creation. In the meantime, the Fed must continue to stand ready for a major financial catastrophe, the risks of which are closer to 1 in 3 than 30 billion to 1. The global financial system and the American economy are far from being out of the woods, and anything that makes life harder on the financial system must be approached with caution. Extra bank reserves are a good thing, but let’s advance toward that goal slowly.

— Jim Lacey is professor of strategic studies at the Marine Corps War College. He is the author of the recently released The First Clash and Keep from All Thoughtful Men. The opinions in this article are entirely his own and do not represent those of the Department of Defense or any of its members.