The Gnomes of Basel
The banking system needs reform. But the Bank for International Settlements hasn’t a clue how.


Jim Lacey

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.