Over at EU Referendum blog, there is a good item about the regulatory system which to a degree, lies at the heart of the current market turmoil. It refers to the network of rules known as Basel II, taking their name from the fact that the headquarters of the Bank of International Settlements is based in the Swiss city. BIS is the place that central bankers meet regularly to discuss regulations governing the world’s main banks and other financial institutions. I used to go to Switzerland quite a bit to sit in on some of the discussions surrounding these rules when I used to report on this sort of stuff. Essentially, the rules lay down how much capital banks should set aside to cover against risks. They are extremely complicated, but in a nutshell, they are designed to protect the financial system from a wave of debt defaults. The Basel II rules have in turn acted as the foundation for bank capital regulations in the EU and other major industrial economies.
If I have a “point” to make here, it is that the existence of these and other regulations utterly nails the lie, put around by a lot of MSM commentators, that what we are seeing is the demise of unregulated, cowboy capitalism. Au contraire, what we have seen is the failure of a large body of rules, assembled over many years, to do what they were supposed to do. In fact, as EU Referendum persuasively argues, these rules may have even worsened the crisis and encouraged financial players to take certain risks “off balance sheet” to avoid having to set aside capital. But you can bet that policymakers will not draw the conclusion that too much regulation might actually be part of the problem.
Excellent post and, being a software developer who has spent most of the last 2 years writing additions to software to handle the Basel regulations, it’s fair to say they are about as much use as a bucket of smashed crabs. As a result, expect more of the same from the big-brains at the central banks.
Charles Dickens nailed what should be the guiding principle for everyone engaged in finance from the simplest of transactions to the most complex and dense. Income twenty shillings – expenditure nineteen shillings sixpence – result happiness. Income twenty shillings – expenditure twenty shillings sixpence – result misery. End of story but too simple for our nuance addicted movers and shakers to understand.
Sorry but doesn’t that kinda invalidate the argument – i.e. that regulation was in existence but was sidestepped because compying it by setting aside capital would reduce the inability of the principal to risk that capital… which was the entire point of the regulation… but basically they just decided to ignore it?
Correct me if I’m wrong of course! I have no dog in this race and I’m not trying to take any particular side…
I am delighted to hear that there are these rules and that a lot of thought has been put into them.
I’d be even more delighted if Johnathon, or anyone else, could explain to me the rules (and thought thereon) concerning off balance sheet debts of limited liability companies.
Best regards
Sorry to lower the tone, but when I saw the headline, I thought you might be talking about this place. It is, of course, in Austria.
Maybe they could formulate the next set of rules there. Then at least they would be appropriately named.
An issue not much discussed is the over-reliance on the existence and structure of regulations.
As one may smile and smile and be a villain still; one may conform and conform and be a danger to the sytem still.
Or, as Alan Greenspan once put it: Bad protection (regulations) drives out good protection (caution and good management.)
One of the changes in Basel II was to create a capital requirement for off-balance sheet assets, because the original Basel rules didn’t have one, so banks started securitising to reduce their capital requirements. In effect, the previous regulations were part of the reason that banks started packaging and selling off debt.
In his brilliant op-ed piece in the Wall Street Journal a couple of weeks ago, in addition to forcefully advocating the abolition of the failed “mark-to-market” accounting rules, former FDIC Chairman William Isaac called for the abolition of Basel II. Here is his main point (although I highly recommend reading the entire article):
Pretty clear, even for the “uninitiated.” The Law of Unintended Consequences always triumphs in the end!
Someone on here needs to write a longish article about David Cameron saying I am not a libertarian – http://www.order-order.com/2008/10/speech-reactions.html
(This) has interesting things to say about Central Banking. Incidentally, although 10% is the legal reserve in the US, the figure is only 2% in the EU and shockingly, 0% in the UK. All this imaginary money wouldn’t have been possible if gold had still been the basis for our money.
Meanwhile, the EU itself is having the vapours about member-states using their own initiative in tackling the liquidity crisis. Apparently doing different things, some of which might work and some of which might not, is “anti-competitive”, which is rather the reverse of my understanding of competition.
This is silly. It’s not a case of too much or too little regulation, but wrong regulation. Common sense alone screams that “off balance sheet” liabilities is a ridiculous concept. Throw in generous amounts of financial industry lobbying, and bribery of our corrupt political elites and you end up where we are today.
Saying ‘corrupt political elites’ implies there is such a thing as ‘non-corrupt political elites’ and that simply ain’t so.
All political systems are engines of corruption, without exception. The only way to abolish corruption in high places is to abolish high places.
Not quite on topic but kinda… I watched a very long, slightly dull, rather conspiracy theory (Rothschilds run the world, thang) video yesterday on Google, kind of thing where the sunk cost fallacy sets in after the first hour. But it got me idly musing as a layman again about this whole fractional reserve banking thing, about which I can never quite make up my mind.
From a Rothbardian POV it’s basically seen as a fraud. Others reasonably argue that it’s not a fraud if the knowledge that the bank is fractional reserve is freely available- lender beware, kind of thing. I can see merit in both views. However we should note that Ponzi schemes are illegal, even if stated to be Ponzi schemes, on the basis that they are fundamentally a broken idea.
But it seems to me that fractional reserve banking is itself, inherently, a broken idea. The whole reason for central banks, then the international bodies like BIS is to prop up this fundamentally broken idea. It works for a while, but it isn’t resilient to crisis. It’s inherently not stable. The mainstream answer seems to be that central banks make it stable, but as we’re seeing now, they don’t. Every time it goes wrong we talk about what rules need to be fixed to make it stable, but it seems to be intrinsically impossible.
So the thing seems to me to be that people say “if we didn’t have fractional reserve banks, there would be no credit, and then there would be no funding for business”. So now I’m kind of getting to my actual point which I hope some wise financial heads may address in reply. Is it really true that you can’t have capitalism without immense quantities of invented credit? Or is that just merely how things are at the moment, and we presume things couldn’t run any other way? If that is true, then what one is effectively saying is that progress, increased production and the resultant wealth creation are impossible without the bank/credit system and without it it would be impossible to progress beyond living in mud huts. That seems, well, ridiculous to me.
Is it that the existence of the credit system has created a version of progress reliant on it? Does for instance the existence of easy mortgages simply allow propery prices to escalate? If there were no mortgages, would there be no houses, or would there be cheap houses, since the price could not rise above what people could actually afford to pay, rather than rising to what level they are able to borrow? Or would it just create societies in which a very few owned all the houses and the rest of us all had to rent?
Can you have successful capitalism without credit beyond that available from savings?
Ian B,
But it seems to me that fractional reserve banking is itself, inherently, a broken idea. The whole reason for central banks, then the international bodies like BIS is to prop up this fundamentally broken idea.
Partly, but even if there were no fractional reserve banking, credit risk would still exist, which is a major part of the Basel rules. FRB creates liquidity problems, through bank runs where the bank clearly doesn’t have the cash to pay every depositor. This crisis is more a matter of credit risk, because money has been lent to people who aren’t paying it back. The problem is that “savers” think they should be able to get a guaranteed risk free return from lending, which is an inherently risky activity.
“Politics is the art of looking for trouble, finding it, misdiagnosing it,
and then misapplying the wrong remedies.” —Groucho Marx
One thing we don’t see referenced often of late is the issuance of Letters of Credit, and the potential exposures in the world of Reinsurance where once I roamed.
It was my understanding that this was a liquidity issue; banks aren’t lending to each other, and people aren’t buying and selling financial instruments (in the way they were previously), because nobody knows what to price them at, and nobody wants to buy at the nominal prices.
People were told that they did not have to check the specific home loans represented by the securities (on top of which the castles-in-the-air credit was built). Because Fannie Mae and Freddie Mac backed the home loans – and the U.S. government backed Fannie Mae and Freddie Mac.
And even the financial instruments that were not backed by Fannie Mae and Freddie Mac were backed by AIG and other companies “too big to be allowed to fail”.
So there was not capitalism involved in this – it was believe that government stood behind the whole thing.
And (in case anyone thinks I am just Democrat bashing) let us remember who produced the funny money (sorry “expanded the money supply”) which was used for all these political games.
Alan Greenspan – a Republican.
Yes he warned against Fannie Mae – but even if there had been no Fannie Mae, the credit money he issued would have been used in some way.
And any use of credit money is a misuse of it – because new credit money should not exist, it is the very source of boom and bust.
Although this particular misuse was especially toxic.
It might have been designed to cause as much damage as possible.
And some paranoid people suspect it was so designed. Designed to be more damaging than a normal credit money bust – in order to undermine “capitalism”.
Anything with ACORN and Obama involved in it is likely to encourge the paranoia of certain folk – like errrr me.
People were told that they did not have to check the specific home loans represented by the securities (on top of which the castles-in-the-air credit was built). Because Fannie Mae and Freddie Mac backed the home loans – and the U.S. government backed Fannie Mae and Freddie Mac.
And even the financial instruments that were not backed by Fannie Mae and Freddie Mac were backed by AIG and other companies “too big to be allowed to fail”.
So there was not capitalism involved in this – it was believe that government stood behind the whole thing.
And (in case anyone thinks I am just Democrat bashing) let us remember who produced the funny money (sorry “expanded the money supply”) which was used for all these political games.
Alan Greenspan – a Republican.
Yes he warned against Fannie Mae – but even if there had been no Fannie Mae, the credit money he issued would have been used in some way.
And any use of credit money is a misuse of it – because new credit money should not exist, it is the very source of boom and bust.
Although this particular misuse was especially toxic.
It might have been designed to cause as much damage as possible.
And some paranoid people suspect it was so designed. Designed to be more damaging than a normal credit money bust – in order to undermine “capitalism”.
Anything with ACORN and Obama involved in it is likely to encourge the paranoia of certain folk – like errrr me.