Pull Out of Basel III: The Moral Hazard of Government Ratings

Recently and for different reasons, two high-profile players from different parts of the financial sector — JPMorganChase CEO Jamie Dimon and respected banking analyst Christopher Whalen — have called for the U.S. top pull out of the Basel III bank solvency agreement. I agree, and it’s good that at long last these international agreements are finally getting the scrutiny they deserve. They have contributed to the very problems they claim to solve — bad risk management and moral hazard.

The international agreements to ensure the financial stability of banks, Basel I, II, and now the emerging III — claimed to strengthen banks by ensuring that the assets included in banking reserves were well selected. Risk-based capital was the goal — encouraging banks to place greater emphasis on assets that were more secure, less on those more likely to default. But, of course, governments tend to trust governments; thus, sovereign debt (specifically that of “developed” nations and government-sponsored enterprises (GSEs)) received a higher rating and thus, a higher weighting. One unit of sovereign debt was the equivalent of more than four units of ordinary commercial loans. Not surprisingly, banks shifted toward the former.

Much of the risks that they now face were the result. Was a Greek bond really four times less risky than a loan to ExxonMobil? And should a Greek bond be viewed as having the same risk as one from Germany or Texas? Government ratings are crude instruments in a highly differentiated and complex world.

Efforts to outsource the rating game — as with the creation of the system of the government-designated Nationally Recognized Statistical Rating Organizations (long limited to S&P, Moody’s, Fitch) — perhaps work a bit better but the entanglement of private firms given special government recognition creates a risk that these once-private firms temper their judgements based on politics. Why, for example, have such firms traditionally adopted the policy that a private loan could never be rated higher than that of the nation in which it operates? Again, is a Chevron bond really less risky than one from the state of California?

Risks are subjective; politics seeks certainty and does so by creating “objective” measurements of risk and uncertainty. But, as Hayek and others have noted, knowledge in a modern society is dispersed and localized. Who better than the loan officer (in a world not distorted by the moral hazard biases arising from government guarantees — implicit and explicit) is better equipped to determine the riskiness of any specific loan? They may well err but the very dispersal of such risk assessment given the diversity of financial entities in our society would mean that errors would be less uniform,  more dispersed, leaving the system more resilient.

It is time to realize that no one can make the financial sector risk free. Indeed, only governments would even think of attempting to do so. Those attempts are increasing such risks — encouraging correlated actions that, when in error, translate small losses into systemic risks. Isn’t it time to privatize the risk management system again, to begin to roll back the guarantees (from the FDIC insurance of the 1930s to the Dodd-Frank guarantees of today) and seek to restore a world in which those who took risks both realized the gains and experienced the losses?