Relax Basel II's Bank Capital Adequacy Requirements

by: Jan VanDenBerg

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 Addictive drugs should be withdrawn and international banking should live clean and sober.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.