Join Early Retirement Today
Reply
 
Thread Tools Search this Thread Display Modes
How Regulators Herded Banks Into Trouble
Old 12-03-2011, 11:29 AM   #1
Thinks s/he gets paid by the post
FIRE'd@51's Avatar
 
Join Date: Aug 2006
Posts: 2,322
How Regulators Herded Banks Into Trouble

Interesting op-ed in today's WSJ by Peter Wallison.

Basically, he argues that the capital requirements set by the Basel rules, encouraged banks to unwittingly hold what proved to be more risky assets during our mortgage meltdown in 2007-2008 and today are responsible for European banks holding too much sovereign debt.
__________________

__________________
I'd rather be governed by the first one hundred names in the telephone book than the Harvard faculty - William F. Buckley
FIRE'd@51 is offline   Reply With Quote
Join the #1 Early Retirement and Financial Independence Forum Today - It's Totally Free!

Are you planning to be financially independent as early as possible so you can live life on your own terms? Discuss successful investing strategies, asset allocation models, tax strategies and other related topics in our online forum community. Our members range from young folks just starting their journey to financial independence, military retirees and even multimillionaires. No matter where you fit in you'll find that Early-Retirement.org is a great community to join. Best of all it's totally FREE!

You are currently viewing our boards as a guest so you have limited access to our community. Please take the time to register and you will gain a lot of great new features including; the ability to participate in discussions, network with our members, see fewer ads, upload photographs, create a retirement blog, send private messages and so much, much more!

Old 12-03-2011, 12:39 PM   #2
Thinks s/he gets paid by the post
FIRE'd@51's Avatar
 
Join Date: Aug 2006
Posts: 2,322
It's possible that this article will not be able to be read by non-subscribers to WSJ online, so I've pasted it below:

For many in the U.S., the worrisome events occurring in Europe recall the 2008 financial crisis. If Greece or some other country should fail to meet its debt obligations, the result could be much like the 2007 mortgage meltdown in the United States. Many banks and other financial institutions in Europe, and some in the U.S., may be weakened by the loss in value of the sovereign debt they hold. Why is all this happening again?

The important factor in both the American and European cases is what is known to scholars as a common shock—a sharp decline in the financial condition and regulatory capital of a large number of financial institutions because a widely held asset has suddenly lost its value.


In the U.S., this shock came when the 10-year housing bubble deflated and U.S. financial institutions were weakened by a sudden loss in value of the mortgage-backed securities (MBS) they were holding, especially those based on subprime mortgages. Mark-to-market accounting did the rest, requiring banks to write down the value of their MBS assets until they appeared unstable or insolvent.


In Europe, the problem is similar and so is its source. Europe's banks, like those in the U.S. and other developed countries, function under a global regulatory regime known as the Basel bank capital standards. Basel is the Swiss city where the world's bank supervisors regularly meet to consider and establish these rules. Among other things, the rules define how capital should be calculated and how much capital internationally active banks are required to hold.


First decreed in 1988 and refined several times since then, the Basel rules require commercial banks to hold a specified amount of capital against certain kinds of assets. Under a voluntary agreement with the Securities and Exchange Commission, the largest U.S investment banks were also subject to the form of Basel capital rules that existed in 2008. Under these rules, banks and investment banks were required to hold 8% capital against corporate loans, 4% against mortgages and 1.6% against mortgage-backed securities. Capital is primarily equity, like common shares.


Although these rules are intended to match capital requirements with the risk associated with each of these asset types, the match is very rough. Thus, financial institutions subject to the rules had substantially lower capital requirements for holding mortgage-backed securities than for holding corporate debt, even though we now know that the risks of MBS were greater, in some cases, than loans to companies. In other words, the U.S. financial crisis was made substantially worse because banks and other financial institutions were encouraged by the Basel rules to hold the very assets—mortgage-backed securities—that collapsed in value when the U.S. housing bubble deflated in 2007.


Today's European crisis illustrates the problem even more dramatically. Under the Basel rules, sovereign debt—even the debt of countries with weak economies such as Greece and Italy—is accorded a zero risk-weight. Holding sovereign debt provides banks with interest-earning investments that do not require them to raise any additional capital.


Accordingly, when banks in Europe and elsewhere were pressured by supervisors to raise their capital positions, many chose to sell other assets and increase their commitments to sovereign debt, especially the debt of weak governments offering high yields. If one of those countries should now default, a common shock like what happened in the U.S. in 2008 could well follow. But this time the European banks will be the ones most affected.


In the U.S. and Europe, governments and bank supervisors are reluctant to acknowledge that their political decisions—such as mandating a zero risk-weight for all sovereign debt, or favoring mortgages and mortgage-backed securities over corporate debt—have created the conditions for common shocks.


But that is not all that can be laid at the door of regulators. Examiners and supervisors operating "by the book" tend to disregard the judgments of bank managements in favor of regulator-approved methods of assessing credits and carrying reserves. As banks begin to conform to regulator preferences, natural diversification declines and all banks start to look pretty much alike. Then, like genetically altered plants, they are vulnerable to a pathogen—like MBS backed by subprime mortgages—that sweeps through the population.


This does not mean that all regulation is counterproductive. Yet the way it is currently pursued under the Basel rules will—through encouraging future common shocks—make the financial system more, rather than less, vulnerable to systemic breakdowns. To create a stable financial system, regulators should encourage asset diversification and do away with the Basel risk-weighted capital system.


Congress then should repeal Dodd-Frank, which authorizes the Federal Reserve to supervise all "systemically significant" nonbank financial firms, thus spreading dangerous conformity to insurance and finance companies, hedge funds and others. Stability can come only when we stop rewarding herding behavior, and penalize it instead.


Mr. Wallison is a senior fellow at the American Enterprise Institute.
__________________

__________________
I'd rather be governed by the first one hundred names in the telephone book than the Harvard faculty - William F. Buckley
FIRE'd@51 is offline   Reply With Quote
Old 12-03-2011, 02:43 PM   #3
Give me a museum and I'll fill it. (Picasso)
Give me a forum ...
Ed_The_Gypsy's Avatar
 
Join Date: Dec 2004
Location: the City of Subdued Excitement
Posts: 5,293
You are criticizing our anointed leaders. This is going into your dossier.
__________________
my bumpersticker:
"I am not in a hurry.
I am retired.
And I don't care how big your truck is."
Ed_The_Gypsy is offline   Reply With Quote
Old 12-03-2011, 07:06 PM   #4
Recycles dryer sheets
 
Join Date: Oct 2011
Location: Park City
Posts: 101
One thing the article seems to be saying is that the Basel rules are flawed, because they encourage banks to ignore the variation in risk across different sovreign debt instruments. The rules do this by requiring that banks meet certain capitalization requirements, which can be satisfied by high-yield investments in debt issued by shaky governments--contrary to the intent of the regulations. The Basel rules don't require banks to invest in this reckless way, they simply fail to prohibit them from doing so. This would seem to suggest that strengthening and refining the regulations would be called for. Yet the article draws exactly the opposite conclusion--which I think is an error.
__________________
sunsnow is offline   Reply With Quote
Old 12-03-2011, 07:15 PM   #5
Give me a museum and I'll fill it. (Picasso)
Give me a forum ...
pb4uski's Avatar
 
Join Date: Nov 2010
Location: Vermont & Sarasota, FL
Posts: 16,470
Seems way too simplistic for me. What the author seems to be suggesting is that these banks made their investments solely based on the required capital implications. While the capital requirements may have subtlety encouraged banks to invest in sovereign debt over other assets, one would hope that the investment managers in these companies would be assessing default and credit risk related to these investments rather than blindly choosing them because they had no capital requirement. If they did chose them simply because they had not regulatory capital strain then I suppose they deserve to go belly up - Darwin was right.
__________________
pb4uski is online now   Reply With Quote
Old 12-04-2011, 06:27 AM   #6
Give me a museum and I'll fill it. (Picasso)
Give me a forum ...
donheff's Avatar
 
Join Date: Feb 2006
Location: Washington, DC
Posts: 8,649
Quote:
Originally Posted by pb4uski View Post
Seems way too simplistic for me. What the author seems to be suggesting is that these banks made their investments solely based on the required capital implications. While the capital requirements may have subtlety encouraged banks to invest in sovereign debt over other assets, one would hope that the investment managers in these companies would be assessing default and credit risk related to these investments rather than blindly choosing them because they had no capital requirement. If they did chose them simply because they had not regulatory capital strain then I suppose they deserve to go belly up - Darwin was right.
+3
__________________

__________________
Every man is, or hopes to be, an Idler. -- Samuel Johnson
donheff is offline   Reply With Quote
Reply


Currently Active Users Viewing This Thread: 1 (0 members and 1 guests)
 
Thread Tools Search this Thread
Search this Thread:

Advanced Search
Display Modes

Posting Rules
You may not post new threads
You may not post replies
You may not post attachments
You may not edit your posts

BB code is On
Smilies are On
[IMG] code is On
HTML code is Off
Trackbacks are Off
Pingbacks are Off
Refbacks are Off


Similar Threads
Thread Thread Starter Forum Replies Last Post
Best way to transfer large sum between banks? Karloff Other topics 26 11-02-2011 08:36 PM
The Banks - Whadaya Think chinaco FIRE and Money 27 09-13-2011 06:12 AM
Low Interest Rates and Banks Investments chinaco FIRE and Money 4 07-16-2011 02:29 AM

 

 
All times are GMT -6. The time now is 11:37 AM.
 
Powered by vBulletin® Version 3.8.8 Beta 1
Copyright ©2000 - 2017, vBulletin Solutions, Inc.