February 28, 2008

Don’t just blame Basel II, Basel I where it started is also to blame

Sir Harold Benink and George Kaufman wrote that “Turmoil reveals the inadequacy of Basel II” February 28 and I disagree. Basel II has not even been fully implemented yet and what the turmoil really reveals is that Basel I is also inadequate.

Among other Benink and Kaufman recommends more discipline in the oversight by the markets but mention as a problem the lack of incentives for professional investors to use information in an optimal way. Of course they are right. What is the sustainable incentive in a system that no matter what the bank could think of a credit it is still the credit rating agency that calls the shots? The way out of this conundrum that I have been proposing for quite a while now is to include the minimum capital requirements calculated as current with the help of the credit rating agencies as a footnote and impose on the banks a minimum percentage of capital to assets requirement, for instance 8 percent.

Doing so would free us not only from the regulatory arbitrage that has stimulated banks to hide risks in other places but also from that systemic risk produced by the credit rating agencies and that has entities like the monolines sweating out ways of how to respond to crazy ultimatums type “you got five days to find capital or I downgrade you and you’re history”, something especially painful considering that if the credit rating agencies had done their job correctly in the first place the monolines would never have been in their current predicament.

PS. Update December 2012. When I wrote this comment I was not aware of how much of Basel II had been implemented in Europe and I had also since 1997 been expressing concerns about Basel I.