I haven’t been following the Basel III negotiations, but two of my favorite bloggers, Felix Salmon and John Carney, have written useful posts on the subject. Drawing on a news report in Die Zeit, Felix is cautiously optimistic: the capital requirements seem tougher than expected, and this is most likely good news.
But John Carney has identified a potential problem:
A little noticed change in the proposed rules, however, could throw a monkey wrench into plans to reform Fannie and Freddie, the two mortgage giants that have spent the last two years on government life-support. So far, U.S. taxpayers have been forced to pony up around $150 billion for Fannie and Freddie, and the Congressional Budget Office says that the total cost could amount to three times that much.
Policy makers who hoped to eventually remove the costly government subsidies and guarantees for Fannie and Freddie will run into a stumbling block, however, if the Basel III rules are implemented. That’s because Basel III includes a liquidity requirement for banks that will encourage them to buy the debt of the Fannie and Freddie as well as the mortgage-backed securities they back.
In effect, John explains, this is a massive subsidy for the GSEs that will also dramatically increase their systemic centrality:
Banks will load up on GSE obligations, especially in an era where central bank reserves and Treasury bond yields are being depressed by policy-makers seeking to keep sputtering economies afloat. This artificial demand will scramble market signals about the risk taken on by Fannie and Freddie—all but ensuring that Fannie and Freddie will once again unwittingly take on more risk than they can handle. In short, the very same toxic situation created by the once implicit government subsidy of Fannie and Freddie is being baked right into Basel III.
Perhaps even more troubling, this will create a vicious cycle that will make reform of Fannie and Freddie next to impossible. Once banks have loaded up on Fannie and Freddie obligations, there will be no way for the U.S. government to remove government guarantees without triggering a liquidity crisis in banks around the world.
Possibly the most terrifying thing I’ve read in ages. John has followed up on how this limits the freedom of action of U.S. policymakers.
P.S. As my Economics 21 colleague Chris Papagianis observes, the negotiators are in a bind: had they not changed the rules, raising capital requirements would’ve been much tougher. So it’s possible that the U.S. has to decide to take action on the GSEs first, and then return to the negotiating table to revise the rules surrounding how GSE obligations are factored into capital requirements.
I’ll also add that I think I’m with Felix on the question of whether we need capital requirements. Of course, John is making a far more comprehensive case against the regulation of financial markets that is hard to evaluate, and I’m strongly disinclined to dismiss his arguments out of hand.