Basel Becomes Babel as Conflicting Rules Undermine Safety

Photographer: Peter Foley/Bloomberg

Former chairman of the U.S. Federal Deposit Insurance Corp. Sheila Bair said, “We’ve accomplished a lot since the crisis, such as rules separating risky activities from simple banking or resolution mechanisms for the biggest firms. But many of the old problems remain, like Basel letting banks model their own risk. And it’s all gotten much more complicated.” Close

Former chairman of the U.S. Federal Deposit Insurance Corp. Sheila Bair said, “We’ve... Read More

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Photographer: Peter Foley/Bloomberg

Former chairman of the U.S. Federal Deposit Insurance Corp. Sheila Bair said, “We’ve accomplished a lot since the crisis, such as rules separating risky activities from simple banking or resolution mechanisms for the biggest firms. But many of the old problems remain, like Basel letting banks model their own risk. And it’s all gotten much more complicated.”

The first Basel agreement on global banking regulation, adopted in 1988, was 30 pages long and relied on simple arithmetic. The latest update, known as Basel III, runs to 509 pages and includes 78 calculus equations.

The complexity is emblematic of what happened over the past four years as governments that injected $600 billion to rescue failing banks during the worst financial crisis since the Great Depression devised ways to make the global banking system safer. Those efforts have been stymied by conflicting laws, divergent accounting standards and clashing rules adopted by nations to protect their interests, all of which have created new risks.

“They’re like a bunch of bumper cars,” Karen Shaw Petrou, managing partner of Washington-based research firm Federal Financial Analytics Inc., said of revamped banking regulations. “On their own, each might do some good things, but they bump into each other over and over. That could render them useless, or worse perhaps harmful.”

While higher capital requirements, curbs on banks trading with their own money and other rules have reduced risk, they have magnified the complexity of supervision, according to two dozen regulators, bankers and analysts interviewed by Bloomberg News. Even if the new regulations can be enforced, they don’t go far enough to ensure safety, said Robert Jenkins, a member of the Bank of England’s financial policy committee.

Photographer: Jin Lee/Bloomberg

European banks, which aren’t allowed to net as much of the value of derivatives in financial statements, use the same netting as U.S. firms when calculating risk for Basel capital requirements. Close

European banks, which aren’t allowed to net as much of the value of derivatives in... Read More

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Photographer: Jin Lee/Bloomberg

European banks, which aren’t allowed to net as much of the value of derivatives in financial statements, use the same netting as U.S. firms when calculating risk for Basel capital requirements.

‘Catastrophic Mishaps’

“Imagine that until 2007, the rules of the road permitted heavily laden fuel trucks to barrel through urban streets at 100 miles per hour,” Jenkins said in an interview. “After a number of catastrophic mishaps, the establishment decides to reduce the speed limit to 75 mph in school zones. Have we tightened the rules? Yes. Have we tightened them enough? No.”

One reason the trucks have slowed is that the 27 nations represented on the Basel Committee on Banking Supervision agreed in 2010 to require banks to hold more capital, or shareholders’ money, to absorb losses. Dozens of countries including the U.S. have issued other regulations or passed laws to curtail risk, and lenders on both continents have boosted capital and improved its quality since the crisis.

Trading of most derivatives, an opaque $639 trillion market, is being forced onto central clearinghouses, where transactions are backed by collateral. The Volcker rule, part of the 2010 Dodd-Frank Act, the U.K.’s proposed Vickers rule and a European Union version named for Bank of Finland Governor Erkki Liikanen seek to separate riskier trading from other businesses. Seven nations have created resolution mechanisms for an orderly shutdown of their biggest lenders if they fail, according to the Basel, Switzerland-based Financial Stability Board.

System Vulnerable

Still, the global financial system remains vulnerable. Only 11 of the more than 100 nations that vowed to adopt the latest Basel rules met a Jan. 1 deadline to start implementation. The U.S. and the EU, each of which drafted 700-page proposals, are still debating them.

The new capital rules are based on the same principal as the old ones: allowing the largest lenders to use their own mathematical models to determine how much capital they need. The calculations, which assume the banks can predict what’s risky, can involve millions of variables, making them difficult for examiners to review, according to an August report by the Bank of England.

Volcker, Vickers

Moving derivatives trading to clearinghouses may concentrate risk and make those marketplaces too big to fail, requiring government rescues. Rules named after former Federal Reserve Chairman Paul A. Volcker and former Bank of England Chief Economist John Vickers may not succeed in curbing risk. U.S. regulators are still debating where to draw the hard-to-see line between trading and making markets for clients as required by the Volcker rule. Volcker himself has questioned the effectiveness of Vickers’s proposal to insulate trading units.

A cross-border mechanism for winding down failed banks with operations in multiple countries remains elusive, as does the universal adoption of a liquidity requirement that would force the companies to have enough easy-to-sell assets on hand if panic hits and funds flee.

Meanwhile, banks considered too big to fail have gotten even bigger since the financial crisis, increasing the cost to taxpayers if they need to be bailed out. The 22 largest lenders in the U.S. and Europe have increased assets by 26 percent since 2007, according to data compiled by Bloomberg.

“We’ve accomplished a lot since the crisis, such as rules separating risky activities from simple banking or resolution mechanisms for the biggest firms,” Sheila Bair, a former chairman of the U.S. Federal Deposit Insurance Corp., said in an interview. “But many of the old problems remain, like Basel letting banks model their own risk. And it’s all gotten much more complicated.”

It’s ‘Ridiculous’

Banks agree that the complexity has been compounded.

“It has gotten ridiculous, far too complicated,” said Wayne Abernathy, executive vice president of the American Bankers Association, the largest industry lobbying group. “The costs and efforts of complying with all these rules no longer are worth the safety and soundness dividend they provide.”

The Securities Industry and Financial Markets Association, another lobbying group, estimates that regulators will end up writing 29,000 pages of directives once Dodd-Frank is completely in place.

Basel III was the culmination of an effort among nations to overhaul the global financial system after the 2008 crisis. Now, while leaders of the Group of 20 nations continue to talk about cooperation, governments from the U.S. to Switzerland are acting unilaterally to protect their taxpayers from future bank losses.

Fed Rules

The Fed last month proposed that foreign lenders organize their U.S. units as subsidiaries and hold capital independently from their parent firms to make it easier for U.S. regulators to seize local assets in a crisis.

Switzerland, where the banking system is five times the size of the nation’s economy, moved in 2010 to give priority to the resolution of the domestic units of its two largest banks, UBS AG (UBSN) and Credit Suisse Group AG (CSGN), in the event of a failure. That means the Swiss operations could be propped up with government support, while international businesses are left to fend for themselves. Regulators in Switzerland also imposed tougher capital standards on the two firms than Basel requires.

The U.K. has taken similar steps to protect its interests. When the country rushed ahead of other nations in 2009 to impose liquidity requirements on its lenders, foreign banks operating there were forced to comply regardless of their legal structure. The U.K. also has tried to insulate itself from the losses of its financial firms overseas by requiring the British units of those companies to abide by separate capital rules.

Watering Down

Bickering among nations during 2010 negotiations led to a watering down of proposed Basel III standards. While the ratio of capital to assets weighted by risk doubled from the previous requirement to 7 percent, it fell short of the 10 percent initially sought by the U.S. and Switzerland. Germany and France led the opposition, seeking to protect the interests of their biggest lenders, which would have needed to raise more capital than foreign competitors.

Even as the definition of what counts as capital was narrowed, U.S. banks were allowed to continue counting some mortgage-linked assets as equity, those in Europe their minority stakes in other financial firms and Japanese lenders their deferred tax benefits. The last crisis showed that such assets failed to provide a buffer against losses.

‘Window Dressing’

Countries made further changes as they translated the non- binding Basel rules into regulations and laws. The European Commission has sought to soften the definition of capital even more, allowing banks to count as capital some hybrid securities Basel had eliminated. The commission, the 27-nation EU’s executive arm, also omitted from its rules a simpler version of the leverage limit agreed to in Basel. That constraint ignores the risk-weightings used in calculating capital and is based instead on total assets, a tougher standard.

The U.S. rewrote sections to satisfy Dodd-Frank, which barred the use of credit ratings in determining risk.

While previous Basel rounds led to local variations, this time they’re greater, according to Barbara Matthews, managing director of BCM International Regulatory Analytics LLC, a Washington-based consulting firm.

“Number and types of divergences are growing by the day,” said Matthews, a former bank lobbyist and policy maker. “We’ve seen over and over that Basel doesn’t prevent the financial system from blowing up anyway. But do we give up? No. It’s somewhat for window dressing.”

‘A Disgrace’

Matthews points to the lack of a global agreement on cross- border resolution of failed lenders as the reason why countries with the biggest financial systems have decided to go it alone. Karel Lannoo, chief executive officer of the Centre for European Policy Studies in Brussels, blames Europe.

“If you water down Basel III too much, this is what you get,” Lannoo said. “We need to have simple and direct rules, not rules that allow banks and regulators to hide. The current Byzantine Basel III rules and loopholes in the European plan to implement them are a disgrace.”

When rules diverge, lenders can take advantage of what they call regulatory arbitrage -- shifting operations to countries with the loosest rules. That historically has been the case among more developed nations, according to a paper published in the October issue of the Journal of Finance by Joel Houston, a professor of finance at the University of Florida in Gainesville, and two colleagues.

Morgan Stanley (MS) and Goldman Sachs Group Inc. (GS) are telling foreign customers they can avoid new U.S. derivatives rules by routing orders through the banks’ overseas units, Reuters reported Dec. 3, citing company presentations and unidentified sources. The New York-based firms declined to comment.

National Interests

“Banks will always find loopholes to get around these rules, especially if they’re so complicated,” said Mark Adelson, chief strategy officer at BondFactor Co., a municipal bond-insurance firm, and a former Standard & Poor’s chief credit officer. “With all those formulas, they’re like physics books. How can anyone monitor compliance with such complexity?”

The three-decade effort to create global capital standards, while heralded as a triumph of international cooperation, has been driven by national considerations from the start.

Basel I came about because the U.S. and Europe were alarmed by the expansion of Japan’s financial firms, Fed Governor Daniel Tarullo wrote in his 2008 book, “Banking on Basel.” When the rules were adopted a quarter century ago, nine of the 10 largest banks in the world were Japanese. Three years later a real- estate crash led to an economic collapse in Japan, eliminating the perceived threat.

Risk Calculations

Basel II, approved in 2004, was pushed by U.S. lenders that had taken the lead from Japan and wanted to expand further without having to worry about capital restrictions, according to bankers, lawyers, lobbyists and regulators involved in the discussions. They persuaded the Fed that their own risk- management systems had become so sophisticated they could better determine themselves how much capital was needed.

The U.S. never fully implemented the rules because thousands of community banks lobbied Congress to block them, saying they would be at a disadvantage because they couldn’t afford in-house modeling. Still, the biggest lenders began deploying proprietary formulas to come up with risk-weightings for their loans, securities and derivatives -- calculations that underestimated the risk of products tied to mortgages before the 2008 crisis.

Accounting Differences

Today, those formulas allow JPMorgan Chase & Co. (JPM), the biggest U.S. bank, to say that only half of its balance sheet is risky, regulatory filings show. Deutsche Bank AG (DBK), Germany’s largest lender, calculates its risk to be 17 percent of assets.

Conflicting accounting standards further complicate risk- weightings. Basel’s treatment of derivatives is based on Generally Accepted Accounting Principles, known as GAAP, which are used in the U.S. and are more generous in their netting of positions than international standards.

Netting allows firms to offset contracts that appear to go in opposite directions, reducing the risk of loss to zero. In the U.S., it also cancels out winning and losing positions of any kind with the same counterparty. Under GAAP rules, JPMorgan’s $72 trillion derivatives book is whittled down to $80 billion of assets. European banks, which aren’t allowed to net as much of the value of derivatives in financial statements, use the same netting as U.S. firms when calculating risk for Basel capital requirements.

London Whale

That netting doesn’t always work in real life, as demonstrated by JPMorgan’s loss last year of at least $6.2 billion on wrong-way bets on corporate debt made by a trader known as the London Whale. Derivatives that were supposed to offset certain trades ended up going in the same direction as those they were supposed to hedge, increasing losses for the New York-based firm.

Disagreements over how much netting to allow is one reason accounting standards remain far apart after six years of meetings by U.S. and European officials.

“Having such differences makes comparison between banks’ balance sheets in Europe and the U.S. impossible,” said Esther Mills, president of Accounting Policy Plus, a New York-based consulting firm.

If international standards were applied on both sides of the Atlantic, the six biggest U.S. lenders by assets would look almost twice as big on paper as they do now, according to estimates on the FDIC website. That would reduce their simplest capital ratio -- a measure of risk looking at tangible equity as a percent of tangible assets -- to 3.3 percent from 6.3 percent, still better than European banks, which average 2.9 percent.

Former FDIC Chairman Bair has said that ratio should be 8 percent. Thomas Hoenig, the agency’s current vice chairman, has called for 10 percent.

‘Still Dangerous’

More capital can never make the system safe because it doesn’t prevent banks from taking risk, according to BCM’s Matthews. Having a cross-border mechanism for shuttering failed global banks in a way that doesn’t jeopardize other firms is the only way to safety, she said. Such a plan will work only if the countries with the biggest financial markets pledge to share costs of a blowup, not just pay lip service to cooperation.

Others, such as U.S. Senator Sherrod Brown, an Ohio Democrat, say the biggest banks should be broken up and subjected to size limits to reduce their risk to the system and taxpayers. While his proposal hasn’t garnered enough support to become law, four years after the crisis it’s hard to find anyone who believes the financial system is truly safe.

“Banks are still leveraged too much, and the regulatory system is still too easy for them to game,” said Anat Admati, a finance professor at Stanford University and co-author of “The Bankers’ New Clothes,” which will be published next month. “The global financial system is still dangerous, and the banks can still bring down the global economy.”

To contact the reporter on this story: Yalman Onaran in New York at yonaran@bloomberg.net or @yalman_bn on Twitter

To contact the editor responsible for this story: David Scheer in New York at dscheer@bloomberg.net

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