Monday, June 4, 2012

Annals of Silly(?) Policymaking: Procyclical Financial Regulations During a Bank Run Edition

. Monday, June 4, 2012

This (via @dandrezer) does not seem smart:
Banks must raise their core tier one capital ratios to 9pc by the end of this month or face the risk of partial nationalisation. The global Basel III rules are also pressuring banks to retrench.  
The International Monetary Fund said banks will have to slash their balance sheets by $2 trillion (£1.6 trillion) by the end of next year even in a "best-case scenario".
That is only within the European Union, and it came about due to panic over Greece last month. Basically, this means that EU banks have to increase their capital cushions by over 200% by the end of this month. What does that mean?
The Bank for International Settlements (BIS) said cross-border loans fell by $799bn (£520bn) in the fourth quarter of 2011, led by a broad retreat from Italy, Spain and the eurozone periphery.
Note that this just in Europe. But it made me wonder (on Twitter): why do this now? After all, it was Germany that insisted on a longer phase-in period for Basel III during negotiations, while the US/UK/Switzerland wanted that stricter capital requirements. Now the EU is doing a rapid phase-in and tougher capital limits years before they are required to by Basel. And they're doing it in the middle of a bank run during a continent-wide recession. What gives? A few things.

1. Banks do have to get to 9% tier 1 capital by the end of the month, but they don't have to come fully into compliance yet. That is, a lot of junk capital that is prohibited by Basel III -- but was allowed under Basels I and II -- will still be allowed. (ht to @Procyclicality for this point)

2. Nevertheless, this is still a big boost to minimum capital standards. So how will banks come into compliance? Two quick and easy ways are to:

a. Hold more cash.

b. Buy more sovereign debt.

The first of these is contractionary -- it's basically hoarding more cash rather than lending it out -- although the ECB can facilitate it if they want to pump eurozone banks full of cash. Non-euro EU central banks, such as the Bank of England, can do the same thing if they want and the US Federal Reserve has injected a bunch of liquidity into foreign banks when needed in the past as well. As a zero-risk instrument, cash has a zero risk weight, so adding more of it to your portfolio brings your overall capital ratio up.

The second of these is expansionary. OECD sovereign debt also carries a zero risk weight under Basel III, as it did under Basels I and II. This might seem bizarre at first, but remember who's making these rules: OECD governments. And OECD governments want to pay low interest on their debt. To do that, they rig the regulatory rules to make it more attractive for financial institutions to buy that debt. Hence, a zero risk weight in Basel.

So what does that mean? If banks need to boost their capital stock, there are two ways to do it: by raising more capital (e.g. by selling equity) or by shifting their risk portfolio. The former latter will be often preferred to the latter former, so banks are essentially being encouraged to buy sovereign debt (and other zero risk weight instruments) in order to come into regulatory compliance.

Was this the point of this policy? I don't know. Probably it was mostly a freak-out after runs started on Greece and then Spain. But I imagine it was part of the calculus, or at least has become so since. In practice this will likely be a transfer of private funding for public funding. Given that the ECB cannot provide liquidity directly to eurozone governments, but can accept sovereign debt as collateral when lending to banks, this could be part of a stealth bailout program that began when Mario Draghi took over as ECB chief from Jean-Claude Trichet last year. Call it "bailout by regulatory arbitrage".

Will it work? I don't know.

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Annals of Silly(?) Policymaking: Procyclical Financial Regulations During a Bank Run Edition
 
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