The first Basel agreement on global banking regulation, adopted in 1988, was 30 pages long and relied on simple arithmetic. The latest update, known as Basel III, runs to 509 pages and includes 78 calculus equations.
The complexity is emblematic of what happened over the past four years as governments that injected $600 billion to rescue failing banks during the worst financial crisis since the Great Depression devised ways to make the global banking system safer.
- Catastrophic Mishaps – Trading of most derivatives, an opaque $639 trillion market, is being forced onto central clearinghouses, where transactions are backed by collateral. The Volcker rule, part of the 2010 Dodd-Frank Act, the U.K.’s proposed Vickers rule and a European Union version named for Bank of Finland Governor Erkki Liikanen seek to separate riskier trading from other businesses. Seven nations have created resolution mechanisms for an orderly shutdown of their biggest lenders if they fail, according to the Basel, Switzerland-based Financial Stability Board.
- System Vulnerable – Only 11 of the more than 100 nations that vowed to adopt the latest Basel rules met a Jan. 1 deadline to start implementation. The U.S. and the EU, each of which drafted 700-page proposals, are still debating them.
- Volcker, Vickers – Volcker himself has questioned the effectiveness of Vickers’s proposal to insulate trading units.Moving derivatives trading to clearinghouses may concentrate risk and make those marketplaces too big to fail, requiring government rescues. cross-border mechanism for winding down failed banks with operations in multiple countries remains elusive, as does the universal adoption of a liquidity requirement that would force the companies to have enough easy-to-sell assets on hand if panic hits and funds flee.
- It’s ‘Ridiculous’ – Basel III was the culmination of an effort among nations to overhaul the global financial system after the 2008 crisis. Now, while leaders of the Group of 20 nations continue to talk about cooperation, governments from the U.S. to Switzerland are acting unilaterally to protect their taxpayers from future bank losses.
- Fed Rules – Switzerland, where the banking system is five times the size of the nation’s economy, moved in 2010 to give priority to the resolution of the domestic units of its two largest banks, UBS AG (UBSN) and Credit Suisse Group AG (CSGN), in the event of a failure. That means the Swiss operations could be propped up with government support, while international businesses are left to fend for themselves. Regulators in Switzerland also imposed tougher capital standards on the two firms than Basel requires.
- Watering Down – Bickering among nations during 2010 negotiations led to a watering down of proposed Basel III standards. While the ratio of capital to assets weighted by risk doubled from the previous requirement to 7 percent, it fell short of the 10 percent initially sought by the U.S. and Switzerland. Germany and France led the opposition, seeking to protect the interests of their biggest lenders, which would have needed to raise more capital than foreign competitors.
- Window Dressing’ – The U.S. rewrote sections to satisfy Dodd-Frank, which barred the use of credit ratings in determining risk.
- A Disgrace’- “If you water down Basel III too much, this is what you get,” Lannoo said. “We need to have simple and direct rules, not rules that allow banks and regulators to hide. The current Byzantine Basel III rules and loopholes in the European plan to implement them are a disgrace.” When rules diverge, lenders can take advantage of what they call regulatory arbitrage — shifting operations to countries with the loosest rules.
- National Interests – Banks will always find loopholes to get around these rules, especially if they’re so complicated,” “With all those formulas, they’re like physics books. How can anyone monitor compliance with such complexity?”
- Risk Calculations – Still, the biggest lenders began deploying proprietary formulas to come up with risk-weightings for their loans, securities and derivatives — calculations that underestimated the risk of products tied to mortgages before the 2008 crisis.
- Accounting Differences – Conflicting accounting standards further complicate risk- weightings. Basel’s treatment of derivatives is based on Generally Accepted Accounting Principles, known as GAAP, which are used in the U.S. and are more generous in their netting of positions than international standards.
- London Whale – That netting doesn’t always work in real life, as demonstrated by JPMorgan’s loss last year of at least $6.2 billion on wrong-way bets on corporate debt made by a trader known as the London Whale. Derivatives that were supposed to offset certain trades ended up going in the same direction as those they were supposed to hedge, increasing losses for the New York-based firm.
- Still Dangerous- “Banks are still leveraged too much, and the regulatory system is still too easy for them to game,” “The Bankers’ New Clothes,” which will be published next month. “The global financial system is still dangerous, and the banks can still bring down the global economy.”
Source : Bloomberg