Basel Dazzle

“Jean: Don't you know that it is dangerous to play with
fire?
Julie: Not for me. I am insured.”

— from August Strindberg's Miss Julie

Basel III’s newly announced bank capital requirements have received their fair share of criticism from the public media. Many of the opinions shared center on the (expected) limited effectiveness of the increased capital standards.

Indeed it is basic approach to simply bolster the reserve requirement. It has its downsides — stemming growth and lending activities — while also failing to strictly eliminate an eventual default: higher reserves might in certain cases simply allow a troubled bank to linger as a going concern before defaulting, without necessarily staving off the default.

How else to protect against another system-wide financial institution failure?

The first question to answer is whether capital reserves that were in place were being correctly applied and adhered to. If not, it leads one to question whether it is the capital reserves that need increasing or whether it is their application that begs tightening.

Prior capital reserve and accounting requirements encouraged banks to game the system by, among other things:

(1) obscuring their balance sheets and taking as many assets as possible off their balance sheet (see for example the infamous Repo 105; the negative basis trade; Madoff’s supposed year-end movements into Treasuries to thwart auditor supervision; and the various mechanisms uncovered for hiding assets and insurance policies, such as is being alleged in the case of the SEC vs. Sentinel); and

(2) creating, through securitization, phantom diversification benefits that were rewarded by the risk-based capital regimes then in effect.

Thus the converse would be to endorse a system that encourages true diversification on the vanilla asset level — not on complex structured finance and portfolio investment vehicles where diversification is gamed and over-rated (no pun intended). We ought to reward transparency, as well as the usage of up-to-date, reliable, complete and comprehensive data and models, or punish the converse.

To protect against systemic risk concerns, we can further require that the rating agencies, too, remain current on their ratings. This will create a useful buffer against large downgrades, the coup de grâce for many leveraged financial institutions.

From a high-level point of view, one may argue that to avoid a crisis similar to the current one, one has to ensure the incentives that led to our current crisis are adjusted towards promoting active risk management and prudent risk taking. Let’s channel our energies towards fostering an investment environment, a culture of proactive risk, reward and responsibility.