Basel allows banks to play the same dangerous game
Before you read on, do me a small favour and click here [46.18KB PDF].
It's last week's publication from the Basel Committee on Banking Supervision outlining some amendments to the initial proposals put forward at the end of last year to strengthen banks in the wake of the 2008 financial meltdown.
Now I would hazard that even those of you who work or have worked in the banking industry would be nonplussed by much of it.
As is the norm for the Basel Committee - the supreme global decision-making body for banks - the concepts are complex and the language is highly technical.
For most of us, it's an impenetrable document in a mysterious foreign language.
Perhaps that's inevitable.
But just pause for a second. What happened in 2008, the collapse and rescue of the worldwide banking system, touched all of us: it turned a gentle recession into the worst recession since the 1930s; and we'll be living with the consequences, in the form of lower growth and squeezed living standards, for years.
Now imagine that the equivalent disaster had occurred in the airline industry, that almost every aeroplane came within a few seconds of dropping out of the skies.
In the aftermath, and however complex the engineering of a plane may be and irrespective of the intricacies of traffic control, the effort to mend and reform air transport would be conducted in full public gaze, using ideas and phrases understandable to all.
As citizens, we wouldn't tolerate anything else - and nor would politicians and regulators believe for an instant that they could get away with stitching up some ostensible solution in private.
So what is it about banking regulation that makes it inappropriate for discussion in front of the children?
Are banks intrinsically harder to comprehend than modern, computer-controlled aeroplanes? That would be difficult to argue.
Are banks less important to us? Well, few people die instantly when a bank crashes. But when a financial system crashes, and the world becomes poorer, vast numbers of people suffer - and some would indeed die, if the resources available for medical care were to contract.
It is therefore odd that the future of banking is being decided as it has been done for more than 35 years, behind closed doors in the quaint Swiss town of Basel by a committee of unelected central bankers and regulators.
The consequences of carrying on like this will be profound.
For example, it's all very well for the government and the Financial Services Authority to demand that non-executive directors of banks and shareholders in banks must be far better informed about the risks being run by their respective banks - and must be prepared to veto dangerous behaviour by those banks - but how can they exercise that responsibility when it's unlikely that they will understand even a fraction of Basel's rules for measuring and controlling risk?
So the clever clogs executives who run banks will be able to carry on as they have been doing for the past 30 years of globalised financial capitalism, which is to see the Basel strictures as the rules of a game to be exploited for vast profit.
It is inevitable that in any rulebook as long and complex as Basel's that there'll be loopholes and sloppy drafting and great unintended gaps. Banks will deploy their capital where the Basel rules understate the true risks, because that's where the highest rewards are to be found - and of course it'll take the regulators, and shareholders and non-executive directors too long to work out that they've been had.
It's what happened on a massive and devastating scale after the Basel l and Basel ll rules were introduced: banks engaged in too much property lending, in excessive off-balance sheet funding, in far too much lending to each other, in far too much investment in AAA rated securities manufactured out of subprime loans, because these were areas of activity either wholly ignored by the Basel rules or where the risks were not captured by the rules.
Inevitably, there'll be similar consequences from Basel lll, the new code that will determine how much capital banks must hold as protection against losses, how much cash and liquid resources they must hold against the threat of runs, and what proportion of their loans and investments must be financed by debt and liabilities of longer maturity.
Here's the question: rather than a rulebook that'll be even longer than the so-called comprehensive version of Basel ll - which runs to 347 opaque pages - wouldn't it be far better to have some very simple easy-to-understand principles, that capture the spirit of the kind of risks that our society believes are appropriate for any institution that has been given the privilege of taking deposits.
Underneath these principles there would be more detailed rules, giving different risk weightings to different categories of loan, or deeming certain kinds of capital as more valuable and useful than other kinds.
But it would be breaches of the principles that would attract greatest punishment and opprobrium, so there'd be no defence for a bank or banker who pointed to the minutiae of the rules to justify loading up the balance sheet with dodgy investments.
Is there any chance of such principles being agreed? Probably not, because national governments are so fiercely protective of what makes their banks different from banks in other countries.
If anything, that's the big message underlying the gobbledegook in the Basel Committee document I made you read at the outset.
I'll translate three parts for you.
1) On the final page, there's a reduction from 100% to 65% in the "Required Stable Funding factor" for residential mortgages. That helps banks that rely heavily on wholesale funding - finance other than the deposits provided by you and me - to provide mortgages. It's a sop to Germany and the US, where mortgage providers are particularly dependent on such wholesale funding (and, as chance would have it, is also a great boon for the UK's Lloyds Banking Group).
2) On pages 3 and 4, it says that the implementation of a new leverage ratio - a ratio of gross loans and investments to capital - won't happen till 2018 and hasn't been formally agreed yet. That's a sop to France and its banks with their massive derivative exposures, which would otherwise need to raise vast amounts of expensive new capital.
3) Page 1 signals a victory for Canada, which wanted the capital provided by "minority" partners in banks' subsidiaries to be included in those banks' capital ratios. Canadian banks have a fair number of subsidiaries capitalised in this way.
Some would argue that all this national horse-trading is also leading to a very worrying retreat from plans to put much greater emphasis when measuring the strength of banks on the old-fashioned definition of capital, viz equity capital or shareholders' funds - under pressure from EU countries whose banks have far too little of such basic capital.
However there's a bigger point. Which is that we've probably lost the moment when it was possible to simplify banking regulation and sanitize the banking system.
Instead, regulators, central bankers and governments are patching up complexity. So, whether we like it or not, the rest of us will have to delegate even more responsibility in the coming years to the so-called experts at the FSA and in regulatory bodies around the world to prevent the system toppling over again.