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Basel III and its Discontents

If you follow the story of the Basel Capital Accords, you know it's rather tricky business.

The current incarnation, Basel III, is being workshopped even as you read this post.

Regulatory proposals usually begin with the high minded intention of improving market stability, efficiency, transparency and so on.

But they usually fail to achieve any of those goals.

The reasons for failure are manifold: Markets are dynamic and difficult to handicap, every trade has two sides, risk is difficult to quantify. And so on.

In fact, there may be nearly as many reasons for regulatory failures as there are failed regulatory regimes. (Ok: Not quite as many — but you get the point.)

Joseph Cotterill, at The Financial Times Alphaville, wrote a recent piece hashing through some potential points of failure for Basel III.

The primary problem is that banks can still carry highly rated sovereign debt as zero risk weighted assets on their books. In light of the deterioration of credit quality of many European sovereigns, this is obviously risk-weighting divorced from reality.

Perhaps more interestingly, Cotterill points out that there is a general shortage of real AAA assets circulating for banks to use as high quality reserve assets.

Cotterill quotes the Basel III working documents:

"Some jurisdictions may have an insufficient supply of Level 1 assets in their domestic currency to meet the aggregate demand of banks with significant exposures in this currency. In addition, in several of these currencies, the supply of Level 2 assets may be very limited. To address this situation, the Committee has agreed to develop alternative treatments for the holdings in the stock of liquid assets. This treatment will apply to very few jurisdictions and currencies where insufficiencies of liquid assets exist…"

What happens in this case? What are banks with a domestic currency bereft of high quality debt to do?

The obvious answer would be to purchase debt denominated in other currencies. But, of course, that introduces foreign exchange risk into the equation.

And in order to hedge that FX risk, you have to enter into interest rate swaps or derivatives.

"Of course, this might provide the very reason that FX and interest-rate swap markets are growing strongly; to keep up with banks’ demand for turning (for example) UK gilts into Australian government bonds," Cotterlli writes.

Suffice to say: there are strong reasons to be skeptical about the effectiveness of any regulatory regime that is spinning off these kind of complications even if it is in place.

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