March 13, 2015

The pro-big-governments Basel Accord trumped the pro-private sector Washington Consensus

In July 1988 the Basel Committee on Banking Supervision put in place the Basel Accord, “The International Convergence of Capital Measurement and Capital Standards” Basel I.

Those standard imposed the following risk-weights, which would determine the equity banks needed to hold against different assets:

0% - For cash, central bank and government debt and any OECD government debt

0%, 10%, 20% or 50% - For public sector debt

20% - For development bank debt, OECD bank debt, OECD securities firm debt, non-OECD bank debt (under one year maturity) and non-OECD public sector debt, cash in collection

50% - For residential mortgages

100% - For all private sector debt, non-OECD bank debt (maturity over a year), real estate, plant and equipment, capital instruments issued at other banks

Those risk weights, applied to a basic equity requirement of 8 percent, translated into that banks were then allowed to leverage much more their equity when lending to governments, banks, developing banks and residential mortgages than when lending to the private sector.

And that meant that banks would find it much harder to obtain comparable risk-adjusted returns on equity when lending to the 100 percent weighted private sector than when lending to all other favored with lower risk-weights.

And that meant that the banks of the Western World were de-facto distorted into lending primarily to the public sector, to other banks, and to residential mortgages.

That of course meant that regulators tripped and fouled the efficient allocation of bank credit mechanism.

With Basel II of June 2004, all was made worse because different risk weights were also assigned then to the private sector based on credit ratings.

What did this mean?

That banks would allocate resources preferentially to the public sector.

That banks would allocate more resources for financing the house we live than for financing the creation of the jobs we need in order to pay the utilities and mortgages of our houses.

That banks would concentrate almost entirely on financing what is safe, refinancing the past, and stay away almost entirely from financing the riskier future.

And of course, it all started to go down hill from then.

And here we are more than 25 years later and read Philip Stephens’ "Why the business of risk is booming” without one single reference to what the regulatory forced risk aversion introduced in our banks have done or is doing to our economies.

To think that the Basel Accord with all its pro-big-government implications was introduced about the same time the pro-private sector Washington Consensus was discussed and vilified is truly mindboggling.