Basel III Wouldn’t Have Stopped Lehman’s Collapse

Last week at Minyanville I wrote about the new banking capital adequacy standards, the Basel III Accord, and how they came well short of the reform needed. My basic critique is that the whole Basel system should be abandoned in favor of a regulatory environment that doesn’t need capital requirements but instead imposes the consequences of failure on banks for their own actions. Since that is not likely to happen in the near future, we should be aware of the short comings of the new Basel agreement.

Here is yet another critique of Basel. Even though it comes from a progressive perspective that believes Basel should be corrected to include more government control, this comment on a short coming in Basel is sharp:

Those percentages do not correspond to hard asset values, but rather to “risk-weighted” asset values. Right now, risk-weights are basically determined by ratings on various securities—ratings which proved fundamentally unreliable and potentially fraudulent over the past decade. Combined with the fact that banks themselves get to apply the risk-weightings to their assets, the new Basel III standards are subject to an obvious source of abuse, and will encourage new risks. Banks will apply inappropriate risk-weights in order to take on more leverage while technically conforming to the letter of the law, and they’ll systematically seek out assets that have inappropriately low risk-weights in order to take on higher leverage, fueling asset bubbles in things like, say, subprime mortgage-backed securities.
Under the standards released last night, international regulators did agree that banks must hold equity equal to 3 percent of total assets. That’s as hard as any leverage or capital standard can be, it’s just completely inadequate. To reiterate: 31-to-1 leverage brought down Lehman Brothers, and Basel III will permit 33-to-1 leverage.

Click here for the whole piece, though be warned the conclusion advocates higher arbitrary standards that are based on the same failed system as before. Sure, Basel III has failed in permitting the same activity as what led in part to Lehman’s downfall—but that doesn’t mean the answer is simply to jack up the numbers. It just goes to show that regulators can’t design a foolproof system. It would be much better to have no capital requirements at all—provided we also fixed Dodd-Frank to end the too-big-to-fail problem.