It’s a case of “When Regulations Collide.” As we’ve seen in the energy field, contradictory regulations cost jobs as employers struggle to comply with legal requirements that tell them to do one thing on the one hand and the opposite on the other. Now we’re seeing another example in the field of financial regulation, as regulators face a dilemma between state rules and supranational rules known as Basel III.
The issue in question relates to regulations over a bank’s Liquidity Capital Ratio (LQR). At one point ratios such as this were helpful tools for investors to judge the health of a company. These days, they are the subject of regulations. The LQR will be a requirement for a certain amount of liquid capital to be held by a bank to back its liabilities. Of course, the definition of “liquid capital” can be hazy, so Basel III involves several complex ways of assessing the liquidity of capital. Some mortgage-backed securities will meet this standard.
Unfortunately for U.S. regulators, the Basel rules require that mortgages that qualify as a High Quality Liquid Asset have “full recourse,” which means that the bank will be able to pursue the borrower for the full value of the loan should they go into default. A problem thereby arises because there are 11 states, including California, where borrowers are protected by no or limited recourse. Therefore any banks that have substantial mortgage investments in these states will not be able to count these securities against their capital ratios, even if the securities are extremely high quality AAA-rated.
Federal regulators may fudge the issue, or they might simply exclude the value of mortgages in these states from the capital requirements. If that is the case, it is likely that banks will be less interested going forward in issuing mortgages in these states. This will mean that the less well-off, the people whom the “no recourse” laws or regulations were designed to protect, will be even less able to secure loans to buy a home.
The free market solution to this problem is, rather than heaping complex regulations on top of each other that either contradict themselves or institute perverse incentives, to allow banks to compete for custom on the basis of different contractual arrangements and to judge for themselves the amount of capital they need to back up the risk of their investments. There is historical evidence that, before the advent of complex regulations, large US banks held much higher levels of capital than they do now.