When Regulation Makes Things Worse -- Banking Edition

One of the factors in the financial crisis of 2007-2009 that is mentioned too infrequently is the role of banking capital sufficiency standards and exactly how they were written.   Folks have said that capital requirements were somehow deregulated or reduced.  But in fact the intention had been to tighten them with the Basil II standards and US equivalents.  The problem was not some notional deregulation, but in exactly how the regulation was written.

In effect, capital sufficiency standards declared that mortgage-backed securities and government bonds were "risk-free" in the sense that they were counted 100% of their book value in assessing capital sufficiency.  Most other sorts of financial instruments and assets had to be discounted in making these calculations.  This created a land rush by banks for mortgage-backed securities, since they tended to have better returns than government bonds and still counted as 100% safe.

Without the regulation, one might imagine  banks to have a risk-reward tradeoff in a portfolio of more and less risky assets.  But the capital standards created a new decision rule:  find the highest returning assets that could still count for 100%.  They also helped create what in biology we might call a mono-culture.  One might expect banks to have varied investment choices and favorites, such that a problem in one class of asset would affect some but not all banks.  Regulations helped create a mono-culture where all banks had essentially the same portfolio stuffed with the same one or two types of assets.  When just one class of asset sank, the whole industry went into the tank,

Well, we found out that mortgage-backed securities were not in fact risk-free, and many banks and other financial institutions found they had a huge hole blown in their capital.  So, not surprisingly, banks then rushed into government bonds as the last "risk-free" investment that counted 100% towards their capital sufficiency.  But again the standard was flawed, since every government bond, whether from Crete or the US, were considered risk-free.  So banks rushed into bonds of some of the more marginal countries, again since these paid a higher return than the bigger country bonds.  And yet again we got a disaster, as Greek bonds imploded and the value of many other countries' bonds (Spain, Portugal, Italy) were questioned.

So now banking regulators may finally be coming to the conclusion that a) there is no such thing as a risk free asset and b) it is impossible to give a blanket risk grade to an entire class of assets.  Regulators are pushing to discount at least some government securities in capital calculations.

This will be a most interesting discussion, and I doubt that these rules will ever pass.  Why?  Because the governments involved have a conflict of interest here.  No government is going to quietly accept a designation that its bonds are risky while its neighbor's are healthy.  In addition, many governments (Spain is a good example) absolutely rely on their country's banks as the main buyer of their bonds.  Without Spanish bank buying, the Spanish government would be in a world of hurt placing its debt.  There is no way it can countenance rules that might in any way shift bank asset purchases away from its government bonds.

  • ben

    In effect, capital sufficiency standards declared that mortgage-backed securities and government bonds were "risk-free" in the sense that they were counted 100% of their book value in assessing capital sufficiency. Most other sorts of financial instruments and assets had to be discounted in making these calculations. This created a land rush by banks for mortgage-backed securities, since they tended to have better returns than government bonds and still counted as 100% safe.

    How do you come to this conclusion? Where in Basil II does it say this?

  • Maximum Liberty

    Warren:

    A couple thoughts:
    1. One of the banking systems in the US in the 1800's required banks to buy government bonds to issue currency. It was basically a way to get those bonds sold. It ended badly. Rothbard's history is amusing on this point.
    2. Arnold Kling has a great insider's perspective on the mortgage- and capital-related aspects of the crash. At the time, he was blogging at econlog.econlib.org; now he's at askblog.com. I'm not going to summarize his thoughts because there's too much nuance for me to do it justice.
    Max

  • Carl

    Basel II defined risk weights for mortgage loans based on loan to valuation ratio, loan type (standard or non-standard) and availability of mortgage insurance. Using these factors, risk-weights for mortgage loans could vary from 35%-100%.

  • Matthew Slyfield

    So, Warren's point is not about the risk weight of individual mortgages, but mortgage backed securities which bundle many mortgages correctly and at the time, almost no one was properly assessing the real risk in these securities.

  • TM

    Question: If one of the purposes of the regulations at hand is to classify the "risk level" of various investments, why not use the built in risk indicators already in the market? Specifically, the expected (and actual) returns for the investments? Obviously it's a bit more complicated, but I would assume even in the big banking world, interest / return rates are still closely correlated with risk? Why try to re-classify investments when we already have a system to help determine risk?

  • joshv

    Well, part of the problem is that regulatory incentives and government intervention have so distorted the market that prices aren't accurate signals. When you've got artificially high demand for an asset, returns will go down - this will signal that the asset is lower risk, when it's really not.

  • Harry

    You make a great point, Coyote.

    As I recall, not long before Lehman went down, banks had to mark their assets to market, a reasonable idea if it is possible to understand the underlying risk. But how does one do that where a debenture is composed of thousands of bits and slices of other debentures? Well, six months before, in March, Lehman Brothers Senior Notes were rated A1 by hubristic CFA's at Moody's, who had talked themselves into believing that the work they had done at Yale and Wharton had made them Masters of the Universe.

    This goes on today. Bonds (debentures) of banks too big to fail rated A or better trade often at higher yields than do plain vanilla corporate bonds rated Baa2.

    But the good news is that our banks have been able to unload their troubled paper onto the Federal Reserve's balance sheet, and have also been able to sell Treasurys at high prices, at least until this October.

  • http://devilish-details.blogspot.com/ mesaeconoguy

    As Josh correctly notes, price signals have become so distorted, they are practically meaningless, and are by no means indicative of actual risk measures. Much of this distortion is due to regulation, and interventionism/stimulus.

    A few weeks ago, the Spanish 10 year bond traded below 2.50% (the US 10 year was around 2.60% simultaneously), indicating that Spanish debt was less risky than US, which is obviously not the case, since Spain is basically a collapsed economy. Ours isn’t quite that far gone, yet.

    Numerous professional traders and portfolio managers have quit their jobs because the price information they are receiving is useless, and the risk mispricings so enormous.

    Our current market position is vastly more dangerous than 2008 because of this massive mispricing and distortion, and if/when the risk reprices (it will have to eventually), look out.

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