Interesting take. Thanks. But I believe the mortgage-backed securities were put together with "liar loans" given to millions of "disadvantaged" Americans who couldn't afford them. Remember, the crisis was originally called the "subprime" but for some reason has been airbrushed out. Eventually, these millions of homeowners stopped making payments, and the cascade of loan failures began.
The real culprits were the politicians like Clinton and G.W. Bush and a host of other actors in the US.
I'm only half way through this article, but I have a few questions.
I don't quite follow the link of Basel as a cause with the plot showing the divergence Barclays assets on GAAP and Basel measures. Basel 1 was agreed in 1988 and law by 1992, yet the divergence of the two measures on the plot clearly has an acceleration point after 1998. 1998 was also the year of one of the most significant overhauls of UK financial regulation. Is the argument that it was the combination of Basel rules and this new regulatory structure that accelerated the divergence? If not, why did leveraging suddenly accelerate at this point and not earlier?
I can't find much on the state of capital requirements in Europe pre-Basel, but the generally stated purpose for that legislation was that many European banks were overly leveraged in the first place. If that's the case, doesn't this mean that Basel was more like a way point for an already existing problem?
I find your arguments on the centrality of Basel rules to the crisis convincing, but to me the timelines suggest Basel rules characterised the way the crisis played out more than triggered it per se.
Dear Liam; Thank you so much for your questions. I am now retired, and I do not get much feedback on my posts. I have lived with and ruminated over these matters for so long that I sometimes don’t realize when my writing is not clear to readers, many of whom are less, well, obsessed than I. Please let me know if anything doesn’t make sense or needs further explanation
I think I will plug most of what follows into my essay as an addendum.
Before Basel, capital requirements were determined by individual national regulators. European banks and US banks had roughly similar capital ratios, although there were big differences in how those ratios were calculated. For example, German banks had large “hidden reserves” of investments in industrial companies whose shares had market values worth far more than their book values.
Japanese banks were the big outliers. At the time that Basel was ratified, Japan was in the midst of stock market and real estate bubbles of colossal proportions. On a GAAP basis, Japanese banks had minimal capital (i.e. stratospheric leverage) but they had immense unrealized gains on investment holdings and real estate. Of course, in 1990 the bubble burst with catastrophic consequences for Japan.
European bank balance sheets began to balloon around 2000. In my opinion, the cause was the advent of the Euro. Suddenly, banks in the larger European countries could make large loans to “periphery” nations (the Baltics, Greece, Portugal) without worrying about foreign exchange risks. Because Basel rated these loans “zero risk”, there was no regulatory constraint on the volume of loans they could make. A couple of years later, they discovered sub prime PMBS, and the rest is history.
To answer your question on Barclay’s let’s consider 2 different scenarios (illustrative but not entirely realistic.)
Let’s say that in 2000, Barclay’s starts out with $1,000 in loans and $50 in equity. It is fully compliant with 5% regulatory capital standards
1. Over the next year, Barclay’s books $200 in commercial loans and retains $10 in equity. Thus, it ends the year with $1,200 in assets and $60 in equity. In this case, the bank will be in compliance with both Basel standards and GAAP standards because Basel assigns commercial loans a 100% risk weight.
2. Over the next year, Barclays makes $1,000 in loans to Greece and retains $10 in equity. Thus, at year end, Barclay’s will have $2,000 in assets and $60 in equity.
From a GAAP standpoint, Barclay’s will be undercapitalized by $40 ((2,000*.05)-60) and will need to issue new equity and suffer the resulting dilution. Implicitly, sovereign credit is weighted 100%, the same as any other asset.
But from a Basel standpoint Barclay’s will be overcapitalized by $10 million. This is because sovereign credit had a risk rating of zero, so as far as Basel was concerned, there was no change in Barclay's assets from 2000 to 2001. AAA rated subprime assets had a higher risk weighting than zero, but the effect on Barclay’s balance sheet was essentially the same.
As I emphasize throughout the paper, Basel’s critical flaw was that it greatly amplified liquidity risk. These additional assets were not funded with deposits, but with short term wholesale borrowings.
Interesting take. Thanks. But I believe the mortgage-backed securities were put together with "liar loans" given to millions of "disadvantaged" Americans who couldn't afford them. Remember, the crisis was originally called the "subprime" but for some reason has been airbrushed out. Eventually, these millions of homeowners stopped making payments, and the cascade of loan failures began.
The real culprits were the politicians like Clinton and G.W. Bush and a host of other actors in the US.
I'm only half way through this article, but I have a few questions.
I don't quite follow the link of Basel as a cause with the plot showing the divergence Barclays assets on GAAP and Basel measures. Basel 1 was agreed in 1988 and law by 1992, yet the divergence of the two measures on the plot clearly has an acceleration point after 1998. 1998 was also the year of one of the most significant overhauls of UK financial regulation. Is the argument that it was the combination of Basel rules and this new regulatory structure that accelerated the divergence? If not, why did leveraging suddenly accelerate at this point and not earlier?
I can't find much on the state of capital requirements in Europe pre-Basel, but the generally stated purpose for that legislation was that many European banks were overly leveraged in the first place. If that's the case, doesn't this mean that Basel was more like a way point for an already existing problem?
I find your arguments on the centrality of Basel rules to the crisis convincing, but to me the timelines suggest Basel rules characterised the way the crisis played out more than triggered it per se.
Dear Liam; Thank you so much for your questions. I am now retired, and I do not get much feedback on my posts. I have lived with and ruminated over these matters for so long that I sometimes don’t realize when my writing is not clear to readers, many of whom are less, well, obsessed than I. Please let me know if anything doesn’t make sense or needs further explanation
I think I will plug most of what follows into my essay as an addendum.
Before Basel, capital requirements were determined by individual national regulators. European banks and US banks had roughly similar capital ratios, although there were big differences in how those ratios were calculated. For example, German banks had large “hidden reserves” of investments in industrial companies whose shares had market values worth far more than their book values.
Japanese banks were the big outliers. At the time that Basel was ratified, Japan was in the midst of stock market and real estate bubbles of colossal proportions. On a GAAP basis, Japanese banks had minimal capital (i.e. stratospheric leverage) but they had immense unrealized gains on investment holdings and real estate. Of course, in 1990 the bubble burst with catastrophic consequences for Japan.
European bank balance sheets began to balloon around 2000. In my opinion, the cause was the advent of the Euro. Suddenly, banks in the larger European countries could make large loans to “periphery” nations (the Baltics, Greece, Portugal) without worrying about foreign exchange risks. Because Basel rated these loans “zero risk”, there was no regulatory constraint on the volume of loans they could make. A couple of years later, they discovered sub prime PMBS, and the rest is history.
To answer your question on Barclay’s let’s consider 2 different scenarios (illustrative but not entirely realistic.)
Let’s say that in 2000, Barclay’s starts out with $1,000 in loans and $50 in equity. It is fully compliant with 5% regulatory capital standards
1. Over the next year, Barclay’s books $200 in commercial loans and retains $10 in equity. Thus, it ends the year with $1,200 in assets and $60 in equity. In this case, the bank will be in compliance with both Basel standards and GAAP standards because Basel assigns commercial loans a 100% risk weight.
2. Over the next year, Barclays makes $1,000 in loans to Greece and retains $10 in equity. Thus, at year end, Barclay’s will have $2,000 in assets and $60 in equity.
From a GAAP standpoint, Barclay’s will be undercapitalized by $40 ((2,000*.05)-60) and will need to issue new equity and suffer the resulting dilution. Implicitly, sovereign credit is weighted 100%, the same as any other asset.
But from a Basel standpoint Barclay’s will be overcapitalized by $10 million. This is because sovereign credit had a risk rating of zero, so as far as Basel was concerned, there was no change in Barclay's assets from 2000 to 2001. AAA rated subprime assets had a higher risk weighting than zero, but the effect on Barclay’s balance sheet was essentially the same.
As I emphasize throughout the paper, Basel’s critical flaw was that it greatly amplified liquidity risk. These additional assets were not funded with deposits, but with short term wholesale borrowings.