New Basel Banking Regulations Mean Every Bank is its Own Cop

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The Basel Committee on Banking Supervision, a global group made up of central banks, just came out with its new bank capital standards, the Third Basel Accord (Basel III), to address some of the problems and weaknesses in global financial regulation.

These problems were seen to have been a partial cause of the global financial crisis.

When banking systems adopt the regulations, which are completely voluntary, it's seen as a step towards greater transparency, a more robust system. It's seen as regulators finally getting tough. This is all part of the mad, frantic scramble for... credibility among regulators.

Sounds Good In Theory

The latest round of Basel III regulations, which were approved and adopted by the Fed just last week, call for banks to begin strengthening and improving the quality of their capital reserves. Quantity and quality of capital are absolutely vital to a healthy banking system.

It was the paradigm of the "honest-to-god, AAA mortgage-backed security," with all of its rubbish quality, willfully overstated and overestimated by U.S. ratings agencies, which helped lead us down the path to collapse just five years ago.

So why not have the banks shore up their defenses, take on more capital of good quality?

It makes sense in theory; the more and better capital a bank has lying around, the better off it shall be when it starts to rain. So what's the problem with the new regulations?

Just Take Our Word for It

As they always have, the Basel regulations let the banks get away with "risk weighting" their capital, which in effect allows them to hold less capital against loans, bonds, and other securities, which are basically perceived - perceived is the key word - to be less risky. The banks get to use their own risk models, not an objective standard.

As our capital wave strategist Shah Gilani likes to say, if you believe Basel III makes the world safer, he's got a bridge in Brooklyn you should check out...

If a bank doesn't think such and such a loan is risky, or such and such a subprime mortgage ABS is risky, and then it doesn't turn out to be, it therefore needs less capital reserves against it - as far as Basel III is concerned.

What standards, other than ratings agencies and past experience account for a bank's perception of the riskiness of its assets? When we find out, we'll be sure and let you know.

The new Basel regulations, as interpreted by the Fed, suggest that banks have the capital equivalent of between 7% and 9% of their total outstanding loans on hand. The larger the bank, the more capital at hand is required. How those reserves are weighted for risk is entirely up to the banks.

Some regulators and watchdog groups feel that the Basel regulations still don't go far enough. They argue that the Basel reserve requirements just aren't enough to protect a bank from a big shock, and won't be until the requirements reach well into double-digit percentages.

Their litmus test is whether or not a bailout will be needed in the event of massive failure, and the answer under Basel III is still a resounding yes. So long as too-big-to-fail remains on the table as a condition, they say, the system will never be strong enough to survive the worst.

Radical or Sensible?

There is a radical (although some would say only sensible) provision being considered that would make an end run around all that fuzzy risk weighting. This is the leverage ratio. Banks would need to hold capital at a fixed percentage of total assets, completely setting aside any risk weighting. This number may need to be as high as 8%.

And some bankers and government officials feel the new capital regulations go too far, saying that these new reserve requirements will have a negative effect on lending, despite the persistently crunchy, creaky credit market before these rules.

A lot of these banks are already reporting that they have a goodly amount of reserve capital on hand, so they are now "optimizing," that is to say, fudging the numbers, on the risk weighting of their Tier 1 and 2 holdings. Instead of focusing on owning common stock and retained earnings, you know, good solid capital, the banks are just polishing up the dubious quality of many of their assets on hand.

The United States Is a Special Case

In the United States, the implementation of the new Basel III regulations is made more complicated by the Dodd-Frank financial overhaul law. Any new Basel regulations need to coexist, compliment, not preempt, and generally get along with Dodd-Frank in all of its arcane glory.

Other big economies, which might be more sensitive to or fearful of an utter and massive collapse of the global financial system, are racing to beef up those actual Core Tier 1 assets.

SNL Financial reported that BNP Paribas SA (EPA:BNP), Deutsche Bank AG (NYSE:DB), HSBC Holdings plc (NYSE:HBC) have already managed to surpass that 9% threshold. It's unclear what, if any, steps U.S. banks are taking to improve their fundamentals ahead of the year-end deadline.

All the stress tests, all the measures taken to ensure the Great Collapse isn't repeated, all will come to nothing unless the regulations we've set up to guard against the fateful day aren't made more meaningful. You can be sure that, despite everything Basel III purports to solve, there will be another meltdown. As Shah Gilani says, it's not a case of if, but when. And when the next meltdown happens, it will be no accident.

He predicted the FHA debacle. He says watch out for a second subprime crisis. And he can show you how to make money on the volatility that's only going to accelerate in the future. Read this special report and learn the secret of how to profit from "The Fear Index" that only gets better as the world collapses.