Friday, December 31, 2010

The Politics of Basel III [1/2]

. Friday, December 31, 2010

Basel III has not been settled yet; the kinks are still being ironed out. And some observers, like Joseph Cotterill at Alphaville, aren't too happy about the goings-on:

Can we talk a bit more about the scandal of Basel III allowing banks to give government bonds a zero risk weighting on their books? This time regarding Basel’s liquidity rules.

Sure. Governments negotiating Basel will leave the provision in because they want banks to buy their debt at low prices. Giving them capital relief for doing so is one way of ensuring that continues to happen. Is that scandalous? Maybe. But it's basic political economy. It gets more complicated, and I encourage everyone to read Cotterill's very good summary post for the details, but the culmination is this:

This would present a difficult situation for banks to be sure. They’d be asked to take on exposure to assets they might not want otherwise, in return for regulatory certainty.

This gets right at what Jeffrey Friedman argues was a central cause of the crisis: banks were incentivized to hold assets -- particularly certain types of asset-backed securities -- because of the regulatory structure imposed on them, rather than for any rational investment reasons. Friedman originally proposed this explanation in a special issue of Critical Review (which he edits). His original chapter is here, and it has now been expanded into a book.

Anyway, it's not a surprise to see this continue in Basel III, but it means that the banking sector will continue to be susceptible to sovereign debt crises, and that governments will be able to get easier funding than they ought. Obviously this can lead to a vicious cycle. We've seen it already, but because Basel III tightens up capital and liquidity regulations the incentives to get capital relief by holding zero risk-weighted bonds will be even stronger. Not a recipe for public fiscal discipline and private financial stability, if you ask me.

The Politics of Basel III [1/2]




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