The New and Improved Cracks in the Bank Capital Framework

Last week and the week before, the European parliament heard testimony from a number of expert sources on the proposals to revamp Basel 2, the set of banking policies created and maintained by the Switzerland-based Bank of International Settlements (BIS). The set of reforms still under consideration are currently using the working title “Basel 3” — and like it or not, this change is coming, and coming in ways that will almost certainly effect the global economy, the big banks, and your bottom line. Indeed, as economic times get tougher and tougher, Basel requires a larger and larger capital cushion — this means less credit for the street, at a time when the street needs it most. Currently, as with financial reform in the United States, the BIS Basel Committee on Banking Supervision (BCBS) regulators are looking to build on existing platforms in order to prevent this sort of crisis from happening again. Since nothing is ever truly ‘new and improved’ and can only be either/or, those global framework builders are unsurprisingly opting for the latter option. The theory is that by laying more floorboards, less will slip through the gaps. Yet after reviewing both sides of the regulatory argument, it seems clear that the foundation still runs the risk of remaining cracked. And the house is perhaps bigger than regulators are realizing. Consider that Basel 2 requirements are especially applicable to those financial institutions holding assets of at least quarter of a trillion dollars or foreign exposures of more than ten billion dollars. These are same institutions that hold and manage more than half the total assets and foreign exposures in this nation. These are the so-called too-big-to-fail entities, of which Stefan Walter, Secretary General of the BCBS focused on in his pro-Basel 3 testimony to the European Parliament:

“A significant proportion of the reforms are targeted at those firms and activities that are systemic in nature. In particular, capital requirements have been increased for trading book activities, counterparty credit risk, and complex securitizations and re-securitizations. Thus, under the newly proposed BCBS standards, systemically important banks will be subject to tougher standards.”

Joseph Mason, a finance professor at Louisiana State University and fellow speaker at the European Parliament on Basel 3, also provided testimony and in it he said “it is important to recognize that misguided policies can create systemic risk.” In a private follow-up conversation, Mason basically said that he felt Walter’s position lacks a truly forward-looking appeal. When dealing with historical collapses, we agreed, the use of the same historical, yet ‘improved’, regulations that helped get us here in the first place is somewhat out of touch with reality. Let’s take a clear example of this logic in action. Walter’s testimony mentions counterparty credit risk, the subject of my column last week. In a June white paper from the Professional Risk Manager’s International Association (PRMIA), titled “Strengthening the Resilience of the Banking Sector,” 360 risk managers were surveyed for their opinions on Basel changes. One important trend the PRMIA noted is that “there has been a clear move to encourage a greater use of central counterparties (CCPs) and to migrate opaque OTC derivatives to the relative transparency of the exchange-based environment.” So the BCBS is proposing CCPs to mitigate counterparty risk? When PRMIA asked how this would affect the financial industry, they concluded that “regulators may be less encouraged by the fact that only 6.9% of respondents feel CCPs are a panacea to the problems with counterparty risk and disappointed by the fact that 16% feel that CCPs are good in theory but will not work in practice.” Additionally, 77.1% of respondents declared CCPs as a being short of a complete answer to counterparty risk. But perhaps the most worrying result in determining the proper risk resiliency requirements of the world’s largest global financial institutions was that only 8.2% of banks undertake regular reverse stress testing of counterparty risk. 35.1% do so only on an ad-hoc basis, and 56.7% report no such stress testing at all. So the BCBS is pretty successful at identifying where the cracks in the foundations are. Unfortunately it is also growing adept at using the wrong mortar to fix it. Jacob Gaffney is the editor of HousingWire and Write to him.

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