Basel I, II And III: Culprit Of The Financial Meltdown

Includes: BAC, C, JPM
by: ChaPaVe

Basel, Switzerland is home to Art Basel, which was founded in 1970 by gallerists to promote exceptional art. The show has been a phenomenon which has expanded over the years to Miami Beach and Hong Kong. Basel is Switzerland's third largest city with a population of 166,000.

Basel is also the birthplace of the 1988 Basel Accord by the Basel Committee (BCBS) also known as Basel I. It was where central bankers deliberated and forged the first international set of minimum capital requirements for banks using a risk based model. It can also be argued as the birthplace of the 2008 financial meltdown.

We believe the world of finance would be better served without regulators designating what assets are risky and what assets are not. Basel I introduced the concept of risk based capital requirements which in turn gave a minimal risk weighting to home mortgages. This encouraged banks to "load up" on this asset class. Moreover, this led to a feeding frenzy by investment banks to create new flavors of residential mortgage backed securities and other consumer based asset backed paper because they carried a lower risk weighting to commercial loans. These same regulators are now channeling money into various flavors of sovereign debt which has a very low risk and sometimes zero risk weighting. This can be no further from the truth.

It took exactly 20 years for the residential mortgage bubble created in Basel to burst and could take just as long to recover.

Outspoken banking analyst Dick Bove suggested recently that "taking the handcuffs" off of banks will do more for the economy than more quantitative easing. We certainly agree that this is a plausible recommendation given the dismal failure of the Basel Accord in guiding financial institutions on what is risky and what is not. Banking regulators do not make loans, they don't run businesses, they don't fund payrolls. Their only role is to critique what others do usually in a "Monday morning quarterback" scenario.

With the recent JP Morgan Chase (NYSE:JPM) "Whale" saga and the resulting attention to the Volcker Rule and its complexities, we believe that no set of rules can eliminate market risk from our financial landscape. More regulation results in less capital creation which in turn impedes growth and the vicious downward spiral continues. Of course, many of the money center banks like Citi (NYSE:C) and Bank of America (NYSE:BAC) have had their issues with complex financial instruments as well. It seems the Volcker Rule has created more loopholes than existed before it was adopted. Complex regulations are the breeding ground for unintended consequences.

In fact, "handcuff" actions by these banking regulatory bodies is what led to the creation of the hedge fund industry. Hedge funds operate in a primarily unregulated fashion where private, uninsured capital is given to managers who are compensated directly by their results. Recently, the SEC has moved to monitor the larger hedge funds. We hope this will not result in less capital creation.

As our economy "muddles through" this period of dismal job growth and flat-lining GDP, all banking regulatory bodies have emerged as the biggest obstacles in our economic revival. The "moral hazard" principle as it relates to our banking institutions was certainly violated in 2008, where selective curry favoring with regulators helped some institutions and killed others.

We believe that small investors should be given a choice to deposit their money in uninsured accounts within banks and other financial institutions which would fall outside the supervision of regulators. These deposits can be lent or invested into credit hungry and capital starved businesses which want to grow and create jobs. They would be given the benefits if these investments perform and would also participate in the downside if they do not. Deposit insurance is often used as the banner for stiff regulations which make banks gun-shy in making loans or investments in anything that is not regarded as extremely high quality.

While we are not asking the creative folks who run Art Basel to take on the additional role of running the Basel Committee on Banking Supervision, we do believe fresh blood is needed to replace the old world of financial cronyism who steered trillions of dollars, euros and other currencies into mortgage related assets under the guise they were not risky.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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