Basel Negotiators Actually Have Their Heads Screwed On

They are focusing on the right issue

Readers of The Hedged Economist are aware that this blog is hardly a fan of those developing the Basel banking regulations.  Yet, it does appear that they actually understand what the risks to banks are.  On January 7, 2013, the WALL STREET JOURNAL had an interesting article on the status of the Basel negotiations.  It appeared under the title “Rules for Lenders Relaxed: Regulators Agreeto Ease Requirements for Meeting Guideline on Liquidity.”

It is interesting that the reporter discussing the regulations presented the changes as “Global banking regulators watered down a key element of their plan for creating a safer financial system, giving ground to banks…”  Perhaps, the reporter was a former sportscaster and does not understand that financial regulations have financial implications.  This is not a game where one side wins the other side loses.  Either side could win or lose with disastrous results.  The purpose of the regulation is the results they achieve, not the game itself.  The article goes on to explain that the regulators made the changes in response to the fact that banks “argued the rules were unworkable and financially risky [emphasis added].” 

As will be explained below, on key issues the article is wrong about the rules being watered down.  The article discusses Basel regulators decisions on the most important issue: liquidity.  Unfortunately, the article treats, liquidity, as if it were posted to a scoreboard.  What is overlooked is that the very definition of liquidity is what was being negotiated.  Viewed from that perspective, the changes may represent a strengthening of regulations.

As was discussed in “It's a Wonderful Life’ OnRegulatory Policy: The Real Risk,” the maturity mismatch characteristic of banking is unavoidable.  Their liabilities are short run while their assets are long run.  The classic example is that deposits can be pulled without advanced notice, but the banks’ loans cannot be called immediately.  Consequently, the greatest risk to banks is that they will not have the liquidity to meet withdrawals.

Where the article goes astray is in its assessment of what produces liquidity.  For example, it reports that “The liquidity rule requires banks to be holding enough liquid assets—originally limited mostly to cash and government bonds—to be able to withstand an intense 30-day liquidity crisis similar to what occurred in fall 2008.”  Under mark-to-market accounting, the value of government bonds can drop as much or more than many other assets.  US investors only have to remember what happened to government bondholders during the 70s and early 80s when government bond holders got crushes.  Europeans, on the other hand, have a more recent example in Greek bonds.

Liquidity is not just being able to sell an asset: it also involves not taking a bath or losing one’s shirt when the asset is sold.  An asset is only liquid if one can get a decent price for it.  To ensure that they would have some assets that were retaining their value, banks lobbied for the inclusion of a large number of “high quality liquid assets.”  Their contention was that it should include a diverse array of assets: “everything from blue-chip stocks to mortgage-backed bonds to stashes of gold.”  It took the European debt crisis, which has seen some governments' bonds become junk-rated and illiquid, to convince the Basel Committee that a diversified portfolio provided liquidity better than a portfolio concentrated on a single set of investments.

It is easy to understand why it took the European financial crisis to impress upon the Basel Committee the simple fact that a diversified portfolio is liquid.  One only has to look at how this rather commonsense change in their focus is being reported to realize that they suffer from broad media and public lack of appreciation of investment fundamentals.  Keep in mind this article was taken from the financial press.  One would hope the financial reporters would have a better understanding of investment fundamentals. Still, one has to wonder why the Basel Committee did not immediately recognize the legitimacy of the banks’ arguments. 

More than once The Hedged Economist has commented on the excessive dependence on theoretical models of portfolio performance characteristic of the Basel regulations.  Perhaps, the Basel Committee has problems applying their quantitative rigor to more than one asset at a time.  But clearly, a diversified portfolio will, under most circumstances, including a financial crisis, provide more liquidity than a concentrated portfolio. 

Interestingly, what is totally missing from the discussion of liquidity is hedging.  As discussed in a previous posting (“It's a Wonderful Life’ On Regulatory Policy:Focus”), hedging is an important way banks address the maturity mismatch inherent in their business.  What is curious about the absence of reference to hedging is that the OCC is well aware of the role of hedging.  As was pointed out in the previous posting, the former Chief Counsel for the OCC identified the “whale trade” as a likely hedge and a routine aspect of banking.

Given that the Basel III regulations rely heavily on quantitative measurement of risk associated with various investments, one is surprised that they would not extend that analysis to include hedging strategies.  Those familiar with The Hedged Economist probably noted a high degree of skepticism about the quantitative measurement of risk and hedges.  But, the techniques are necessary at bank, and they are extremely effective when applied with the appropriate level of skepticism about the quantitative measurements.

The thought of the Basel Committee looking at hedging strategies is a little bit scary.  The problems with the quantitative methods they use include that they assume a determinant variability of asset prices, and what is even scarier is that they often assume constant variability of asset prices.  The models assume that there is always a market.  Therefore, when addressing liquidity, the assumption of constant variability implies something close to constant liquidity.  Thus, there is a risk that their quantitative methods will assume away the problem regulators should be addressing.  They have not developed models that predict market discontinuities (i.e., interruptions in liquidity).

The article goes on to report other changes that were made.  While the folly of how the article addresses the source of liquidity is apparent, the balance of the coverage does address serious questions about the extent of liquidity banks should be required to hold.  But note that it is the extent of liquidity that is now the focus not the source of liquidity.  No change in the intended amount of liquidity would have any significance if the definition of what is liquid was wrong.  Consequently, while “watered down” may seem more justifiable with respect to the amount of liquidity, it's a quite hollow description without first defining liquidity.

The article uses as an example of the amount of liquidity required.  It states: “the original rule stated that banks needed to assume that, in a theoretical 30-day crisis, they would see 5% of their retail deposits vanish. The banking industry argued that was unrealistically harsh. Sunday's [January 5^th] rule lowers the level to 3%. And instead of assuming that corporate clients would draw down their credit lines by 100% in a crisis, the figure has been changed to 30%, a shift that significantly lowers the amount of liquid assets banks need to have on hand.”  One can draw his or her own conclusions about which scenarios are more realistic for a financial crisis in the 21st century, but, clearly “watered down” is an accurate reflection of the changes in the amount of liquidity.

One has to congratulate the Basel Committee for addressing the right issue.