The Eurocrisis Started in Basel

The Eurocrisis Started in Basel

August 20, 2013
Originally published in Forward

The popular wisdom about the Euro crisis is that it was all the greedy bankers' fault. Yet, we live in a political world, not a true free market. The conventional wisdom simply misses the role that politicians and regulators played in pushing banks towards policies that had disastrous consequences. The role of regulators in the Eurocrisis needs to be more widely known.

To compare, no examination of the subprime mortgage crisis in the US is complete without an appreciation of the Community Reinvestment Act (which pushed lenders towards giving loans to people who proved unable to pay them back) or zoning regulation (which caused housing prices in some areas to skyrocket; areas without these regulations didn't experience a price bubble).

In the Euro crisis, the crucial role of regulators depends on the decisions of an obscure organization, the Bank for International Settlements based in Basel, Switzerland. This “bank for central banks” was founded in 1930 to help facilitate Great War reparation payments from Germany to France. There were credible allegations that it aided German looting of occupied countries during World War II, but it was saved from dissolution by the intervention of John Maynard Keynes, who argued that it had a crucial role to play in international financial regulation.

He was right. In 1974 it provided the secretariat for the Basel Committee on Banking Supervision, and with that group issued the first Basel Accord in 1988. This agreement of banking regulators set international standards for bank capital requirements.

This accord – and the Basel II agreement of 2004 – laid the foundations for the Euro crisis. It gave different weights to capital based on assessments of their risks. So corporate debt was viewed as extremely risky, securitized debt less so, and sovereign debt was viewed as having zero risk.

So, assuming that a bank was required to have capital reserves of 8% of its risk-weighted liabilities, it would require $80 million in reserves to back up $1 billion worth of mortgages (risk weighting 100%). However, if those mortgages were securitized into an A- rated tranche, the risk weighting would fall to 50% and the capital requirement to $40 million. Further measures to turn them into $1 billion worth of AAA-rated Super Senior Mortgage Backed Securities would drop the capital “charge” to $20 million.

This process is known as regulatory arbitrage. The risk weightings encouraged the conversion of simple loans into mortgage-backed securities, which were instrumental in the financial crisis of 2008. Europe, however, went through a further cycle of such arbitrage. As noted, the sovereign debt of most Western economies was regarded as of zero risk under the Basel Accords. This led to a massive conversion of suddenly- risky private debt into public debt, which required not one jot of capital reserves.

We know the outcome. Sovereign debt proved to be a source of significant risk and the Eurozone lurched into a sequence of crises. The attempts by Eurozone politicians to stop the cracks have merely papered over a widening chasm. Regulators have come up with a Basel III agreement that devotes ever- more complex formulae to determining risk weightings. Obviously, there will be space for yet more complex arbitrage.

That is one reason why calls for more banking regulation miss the point. They are like calls to make the offside rule or leg-before-wicket more complex. The game will adjust, but not for the benefit of spectators.

The Basel rules are about capital requirements. As a recent study from the Institute for Economic Affairs found, before the existence of bank regulation (apart from a stern look from the governor of the Bank of England) British banks normally held much more capital in reserve than they do now. Counterintuitively, freeing the banks from the constraints of complex capital requirements might make them take a much more realistic view of the risks of the liabilities they incur.

The Euro crisis started in Basel, not in New York or Greece. To prevent a repeat, it would take a politician of courage to stand up for less regulation of banks. Could there be such a one somewhere near the City of London?