The international bank capital regulations known as Basel III may be weakening the financial system by promoting herd like behavior by the banks.
The new capital requirements require dramatically higher levels of capital, which is intended to make individual banks less likely to fail. But because the regulations treat certain assets as less risky than others, they encourage banks to load up on the same types of assets.
This effect of the capital adequacy rules was confirmed by Jamie Dimon, the chief executive and chairman of JPMorgan Chase , during the fourth-quarter earnings call Friday morning.
Dimon said the bank was concentrating on increasing its exposure to assets that have advantageous risk weighting, while limiting exposure to assets that have disadvantageous risk weighting. What’s more, he said that banks all around the world are doing the same thing.
This isn’t a problem if the regulators have correctly assessed the risk of various types of loans. But regulators have a terrible record of making these assessments.
In the decade or so before the financial crisis struck, regulators gave privileged status to mortgage backed-securities . As a result, the banking systems in the United States and Europe were badly over-exposed to the U.S. housing market.
What Dimon has exposed is that the risk of regulators causing the banking system to amass enormous concentrations of regulatory favored assets is not just a theory. It is happening right before our eyes.
Right in plain sight.
The best discussion of this problem still comes from a 2011 book titled “Engineering the Financial Crisis” by Jeffrey Friedman and Wladimir Kraus. The capital regulations “backfired” and caused the financial crisis, Friedman and Kraus argue.
In many ways, the current crisis in Europe can also be traced back to misguided capital regulations. The earlier round of capital regulations — Basel II — government-rated bonds rated BBB were given 50 percent risk-weightings. A-rated bonds were given 20 percent risk weightings. Double A and Triple A were given zero risk weightings — meaning banks did not have to set aside any capital at all for the government bonds they held.
This lead the banks to seek out sovereign debt, which pushed down the interest rates countries like Greece, Spain and Italy had to pay.
This, in turn, encouraged the governments to borrow on previously unimaginable scales.
Flash forward to 2010, when it becomes clear the government bonds were far riskier than the regulators believed. The entire banking system of Europe was brought to the brink of destruction thanks to the overexposure to sovereign debt the risk weighting encouraged. It took a dramatic change of policy by the European Central Bank to bring some stability to the banks, and even that stability may only be temporary.
Dimon has sounded the alarm bell. The question is whether anyone in power is listening.
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