The Big Bang Leads to the Big Whimper (aka: Basel III)

Remember the good old days in London? The City of London's “Big Bang” and the insanity that was Basel II defined the era in which Western banks became the financial Wild West. It didn't end well. During the U.S. savings and loan debacle I had the great fortune as a regulator to receive policy guidance from one of the leading “law and economics” professors in the nation, Professor Daniel Fischel, soon to be Dean of the University of Chicago's law school. Fischel assured us that the reason that large S&Ls had so little capital was that the markets realized that they bore so little risk that trivial capital levels were ample. The large S&Ls' tangible and market value capital levels were negative – and most of them failed. The specific large S&Ls that Fischel praised – Lincoln Savings and CenTrust – were large accounting “control frauds.” Lincoln was the most expensive S&L failure ($3.5 billion) and Centrust was among the ten most expensive failures. The UK ignored the lessons of the S&L debacle when it adopted an oxymoronic policy of aggressive deregulation and desupervision (“softly, softly”) in its Big Bang. The developed world adopted, through the Basel II process, Fischel's long-falsified claim that trivial capital levels were ample because most large banks posed only minimal risks of failure and loss proved a tad optimistic. Basel II sought to reduce, substantially, capital requirements, particularly for large banks. The large banks were encouraged to use proprietary models to measure their risk and asset values and determine their desired capital. Everyone who was (A) sentient and (B) had been involved in examining financial institutions knew that this would lead to the largest banks understating their risks and overstating their assets and capital levels – and that it would make it impossible for examiners to examine effectively the largest banks. The result was a catastrophe that nearly became the next Great Depression. Basel II was rolled out with all kinds of bright promises. One might expect that the financial press, chastened by the abject failures of the Basel process would react with great caution to the claims made by Basel III's proponents. Instead, the New York Times entitled its story: “Regulators Back New Bank Rules to Avert Crises” and began with this line: The world's top bank regulators agreed Sunday on far-reaching new rules intended to make the global banking industry safer and protect international economies from future financial disasters. The Washington Post was even more gushing: Regulators meeting in Basel, Switzerland, on Sunday agreed to take new steps to immunize the financial system from the sort of crisis that pushed the world into recession two years ago. The Wall Street Journal enthused: Global regulators pushed through a historic remake of the world's banking regulations—forcing financial institutions to increase protections against unexpected losses—with the ripple effects likely to impact everything from mortgages to commercial loans to credit cards in coming years. The new rules are designed to rein in the kinds of risky activities that contributed to the financial crisis that upended Wall Street and shook the global economy to the core. The Financial Times provided the most measured discussion of Basel III, but even it accepted without analysis the claim: Tougher capital standards are considered critical for preventing another financial crisis, but bankers had warned that if the new standards were too harsh or the implementation deadlines too short, lending could be curtailed, cutting economic growth and costing jobs. Well, no. Bank stocks promptly surged precisely because the markets viewed Basel III as so weak. At best, Basel III's nominal capital requirement mostly moves us back to Basel I levels – and no one serious thinks Basel I would prevent financial crises. Yes, Basel II was insane – and it was brought to you by largely the same people that shaped Basel III. But the crisis would have occurred if Basel III had been adopted a decade ago and adopting Basel III will not prevent future crises. Nothing in Basel III addresses the fundamental perverse incentives that cause recurrent, intensifying financial crises. The Enron era “control frauds” should have taught us that we can have financial crises without bank failures. None of the articles about Basel III discussed accounting. The Basel III process has almost entirely ignored accounting even though accounting is the “weapon of choice” in finance. Is there anyone so naïve that he believes that nominal “capital” “requirements” have binding operational force without meaningful, enforced accounting rules? We need to be candid. Actual capital requirements are substantially lower now than in the bad old days of Basel II. They are lower because we – and the Europeans – have adopted unprincipled accounting principles that permit banks to lie about asset values in order to hide their massive losses on loans and investments. The U.S. had a substantially higher minimum capital requirement than European banks because, as weak as our anti-regulators were, they were appalled by Basel II and insisted on a higher capital requirement. If the U.S. adopts Basel III our actual capital requirement for banks with serious unrecognized asset losses will be lower than the actual capital requirements we imposed under Basel II – that's how large the accounting lies are. European banks had no meaningful capital requirement under Basel II, so many of their banks – six years from now when the nominally increased capital rules phase in sufficiently – may eventually (net of the accounting lies that hide losses in their portfolios) have a modestly higher capital requirement. Even that requirement, however, will be lower than Basel I (under honest accounting). Consider two policy implications of the difference between nominal and actual capital requirements. First, if you believe what the authors of Basel III purport to believe – that inadequate capital requirements cause banking crises – then Basel III must fail unless it ends the accounting lies. (I'm actually dubious of this conventional economic wisdom.) Second, when we lie about accounting and leave zombie banks in the hands of those that looted them and caused trillions of dollars of losses we eviscerate our integrity and our efforts at economic recovery. Lying does not work very well – look at Japan. It prevents markets from clearing, it leaves failed banks under the control of failed bankers, and it leaves banks twisting slowly in the wind and unable and unwilling to fund the recovery. I think it is a symptom of how badly we have fallen that I feel the need to explain that lying is bad business. A brief update on my article last week about Kabul Bank and its web of control fraud and corruption: the Washington Post reports today that the administration and our senior officer corps has decided we need to back off our efforts against corruption among our Afghan allies because we are upsetting Karzai and his cronies – “A subtler tack to fight Afghan corruption?” The word “subtler” is a euphemism for “weaker.” Apparently I need to explain that corruption isn't simply immoral – it gets our troops killed and maimed.

Bill Black is the author of The Best Way to Rob a Bank is to Own One and an associate professor of economics and law at the University of Missouri-Kansas City. He spent years working on regulatory policy and fraud prevention as Executive Director of the Institute for Fraud Prevention, Litigation Director of the Federal Home Loan Bank Board and Deputy Director of the National Commission on Financial Institution Reform, Recovery and Enforcement, among other positions.

Bill writes a column for Benzinga every Monday. His other academic articles, congressional testimony, and musings about the financial crisis can be found at his Social Science Research Network author page and at the blog New Economic Perspectives.