Relax Basel II's Bank Capital Adequacy Requirements

Like an old drunk denied his whiskey, the global economy denied easy credit will soon be suffering, shaking and crying for a hair of the dog.

Better give it a little. Withdrawal too sudden can kill.

Of course, in the long run, Basel II should be amended to disallow the use of these extremely dangerous unregulated and unbacked "insurance" (CDSs) to ostensibly improve the quality of bank assets. Bank capital adequacy ratios should be increased and policed more rigorously. Addictive drugs should be withdrawn and international banking should live clean and sober.

But for now, we need something of the opposite. The addict must have a bit of a fix.

Market participants should demand a temporary relaxation of the bank capital adequacy requirements laid out in Basel I and Basel II. Due to the abuse of unregulated "insurance" products, many of which suddenly went up in smoke when AIG hit the skids, actual risk-adjusted bank capital ratios across the globe apparently have been driven far under international standards, as set in the Basel accords. The sudden withdrawal of the bogus "insurance" has apparently created a hole in bank capital so large that simple capital infusions funded by public borrowing may well be inadequate.

Relaxation of Basel II would require action by all the members of the G10.

Calls for relaxing "mark to market" requirements are misplaced. Japanese use of this technique led to a failure to disgorge bad loans, which caused low loan growth to turn into a chronic rather than an acute problem. The short-term ameliorative impact of refusing to "mark to market" will only make worse another short-term problem – hiding ugly secrets can only increase the lack of counterparty trust which is causing the interbank loan market to freeze up.

Better to disgorge the location of these bad assets as soon as possible.

While waiting for G10 action on Basel II, banks can "go domestic" to avoid the Basel Accord. Only banks with international operations need meet Basel reserve requirements. For domestic banks, the required reserve ratios can be reduced by action of national governments.

The United States Federal Reserve should immediately reduce our national reserve requirements for domestic banks. Japan's experience illustrates well the fact that when banks are sick, monetary ease does not result in growth of broad monetary aggregates, as the multiplier is not functioning. Interest rates were nearly zero for a decade in Japan while prices dropped.

This reduction of reserve requirements should be rather dramatic for high quality assets. This would allow regional banks without international activity, which have not indulged in the narcotic of the bogus "insurance" and have good quality assets, to quickly expand credit. This would provide new sources of lending flow to reduce the system shock of the sudden cutoff of credit.

As was done in Japan, banks with only minor international activity should shut those down so they can "go domestic," thereby avoiding the capital adequacy requirements of Basel II. If our national requirements are set under Basel II, this will result in an immediate, costless increase in available credit.

This is one quick, easy step that can be done in many countries simultaneously while the diplomatic process of getting the necessary agreements to relax Basel II can be pulled together.

Comments

[zalo:]

The final tally is that...a hedged position is not a risk free position neither a sold position

2008 Oct 05 05:37 PM

[zalo:]

There is a lot of discussion of what should be the better way to avoid this kind of crisis again in the future. And certainly there is no "perfect" model.

Some say increase regulation, but regulation must be focused to avoid systemic risk, and in order to avoid systemic risk you must ensure that ailing institutions are taken out as quickly as possible in order to avoid its problems groing too large and becoming systemic. By relaxing basel II your are doing the opposite. The problem is that some financials use basel II, others don´t, some have regulation on them, some other don´t.

Some people have said that you should avoid having "too big too fail" institutions, but actually the "too big too fail" institutions are the ones that are saving the "too small to do not fail" institutions. Furthermore, it is not an issue of "too big to fail institutions" but an issue of "too big too fail markets or industry". I think that it is mainly on this second issue that regulators should focus on.

2008 Oct 05 05:47 PM

[jmorace:]

This sounds like a great idea to me.

Although, many small/mid regional/domestic banks have very high loan quality standards and these folks can still get credit now (I think....) So, maybe it wouldn't help, but it can't hurt.

JMorace

2008 Oct 05 07:07 PM

[USC-Col 200...:]

I have to disagree. The removal of any capital adequacy requirement is a terrible idea in a credit crunch especially when a lot of banks are failing. The banks are failing because the profit excess can't be reinvested in the form of money to the loan loss reserves or write off of bad debt expenses. Lowered capital adequacy requirements mean we wouldn't lose as many banks to failure of maintaining ratios. We would just flat out have more lazy, corruptible, and workers in banks who don't understand you're their work, and that maintaing capital adequacy requirement are a main part of the bank's operations. This gives to much leeway to banks especially now. Just keep those requirements and make it up to CEO's and executive of firms that people within that industry DO THEIR JOBS! Because it's obviously that is what the case. If construction workers didn't do their jobs, they're be no reconstruction of roads, no new homes built, no offices being built, etc. If any restaurant did not fulfill the requirement of their work for personal reasons. Or if they didn't serve food, beverages, and whatever entertainment for profti reasons, then they would fail to be a restaraunt. Or if they're were trust issues with food quality, and timing, no one would go. They same should be in the industry, its just worse because you're talking about handling money. I believe capital requirement are motivations for the heads of the companies to make sure the company operations are well-performed, and to protect consumers earned money invested whether through purchase or stock purchases in your company.

2008 Oct 05 07:34 PM

[Ames Tiedeman:]

Change the rules and create another crisis in 5 years.

2008 Oct 05 09:17 PM

[User 265729:]

Jan - Real estate investor for the last 15 years as I see in your bio, eh?

Why don't we just change the rules on banks so they don't have to have any capital at all?

We could call them zero capital banks that hand out zero down loans.

This would make sense to me.

2008 Oct 06 12:14 AM

[Nick Gogerty:]

Basel 2 is extremely dangerous as a model based risk approach it will create gaming of the model. 5-7 years from now after full implementation it will be considered a structural element leading to systemic failures.

2008 Oct 06 10:42 AM

[flow5:]

How does the FED follow a "tight" money policy and still advance economic growth.? (obviously not by lowering reserve requirments and presage another burst of inflation followed by another recession-depression).

What should be done? The commercial banks should get out of the savings business - gradually (REG Q in reverse-but leave the non-banks unrestricted). What would this do? The commercial banks would be more profitable - if that is desirable. Why? Because the source of all time/savings deposits within the commercial banking system, are demand/transaction deposits - directly or indirectly through currency or their undivided profits accounts.

Money flowing "to" the intermediaries (non-banks) actually never leaves the com. banking system as anybody who has applied double-entry bookkeeping on a national scale should know. The growth of the intermediaries/non-ban... cannot be at the expense of the com. banks. And why should the banks pay for something they already have? I.e., interest on time deposits.

Instead of lowering reserves, as the proportion of deposits shifted from time/savings to transactions) would force bank credit contraction by the reduction of excess reserves (exactly the OPPOSITE proposal expoused by Jan VanDenBerg).

Bank credit contraction means, of course, reduced loan volume and reduced bank earnings, but if this is accoomplished by an even greater reduction in bank expenses, bank profits will obviously increase. And it is profits, not size, that is presumably the primary objective of bank managements.

As the proportion of time/savings deposits to transactions deposits is reduced, there would be an immediate increase the supply of loan-funds to the non-banks, and lower long-term interest rates (which would feed back to short-term rates), and the health and vitality of the whole national economoy would improve. The aggregate demand for loan-funds would expand, the volume of "bankable" loans would grow, and so will the banking system -- the FED being willing.

This commentator is Keynesian inspired disciple of voodoo economics and she doesn't have the foggiest idea of what she is talking about.

2008 Oct 06 01:23 PM

[flow5:]

The Financial Services Regulatory Relief Act of 2006 already provides for the reduction of bank capital.

2008 Oct 06 01:57 PM

[flow5:]

That is, the lending capacity of the money creating depository institutions is dependent upon monetary policy. It is not restricted by the volume of bank capital. And the trend rate of the ratio of bank capital to bank liabilities will continue to decline. And there is no magic governing ratio.

The liquidity and solvency of the banks should be based credit worthiness of the loan or investment and not the adequacy of bank capital. Contrary to Sheila C. Bair, chairwoman of the Federal Deposit Insurance Corporation, this is the most important determination of the banks soundness.

2008 Oct 06 02:02 PM

[MurrayL:]

When a bank makes a $200,000 'liar' loan, it did it with about 4% of its money and 96% of funds provided by depositors. The depositors lent money to the banks in anticipation that they would get it back. The capital adequacy requirements exist to ensure that the bank has its own money on the table when it makes the lending decision. It would be great if the banks accepted that they had a fiduciary responsibility for monies entrusted to them, but that is probably unrealistic, so we have capital requirements. The current crisis has shown that they are inadequate - how we arrived at the position that it was OK to run a business with 4% equity will bother us for some time.
But to suggest that the current minimal capital requirements should be weakened further is absurd. This is just a licence for more trouble. If the industry cannot learn to ride with the current trainer wheels, it isn't time to take them off!

2008 Oct 07 04:43 PM