Why New Basel Rules Won't Make Safer Banks

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If there were a banker version of sugarplums dancing in one's head, surely an easing of the liquidity coverage ratio would be it.

The liquidity coverage ratio is new regulatory requirement aimed at ensuring that banks can withstand short-term financial crises. Under rules proposed by the Basel Committee on Banking Supervision, banks will be required to hold a portfolio composed of officially approved "High Quality Liquid Assets" equal to the amount of liquidity outflows they might experience under stressed conditions over thirty days. The basic idea is to make sure banks have enough assets they can easily sell to support a month's worth of liabilities if we have a repeat of 2008 and one or more banks lose access to the credit market and depositors start to flee.

Banks despised the original set of liquidity rules proposed in by the Basel Committee in 2010, although at first they downplayed their opposition and went out of their way to say they support the goals of the new rules. They objected that the proposed rules over-estimated the amount of deposits likely to flee in a time of stress, defined high quality liquid assets too narrowly, and put in place too tight a timetable for compliance.

The Basel Committee on Banking Supervision played the slightly belated Santa Claus role Sunday by delivering the news that banks were getting relief on all three of these objections. The outflow forecasts will be lower, the definition of high quality assets will be expanded, and the rules will not be fully enforced until 2019, four years later than expected. The sugarplums are now well in-hand.

No doubt many bank critics will decry the final rules as a giveaway to the banks. Some folks see loosening any rules as increasing systemic risk, rewarding reckless bankers, and a sign that bankers are once again writing their own rules.

Bank shareholders, on the other hand, will likely cheer the changes. The delayed enforcement should keep bank earnings higher than they would have been, since buying high quality liquid assets generally has a lower return on investment than buying riskier assets. Bank shareholders, who enjoy limited liability because their investments can't go below zero, generally prefer more risk than less.

Even on a risk-adjusted basis, the returns on high quality liquid assets can be significantly lower because banks must-crowd into the officially approved asset classes. This is where the expansion of the definition of high quality helps. By broadening the asset class required by regulators, it reduces some of the squeeze. And the delay in timing should allow the financial sector to produce more of the required assets in anticipation of growing demand.

What's more, the changes in the assumptions about how much liquidity would be drained in a crunch (you can read the details in this post from FT Alphaville's Kate Mackenzie) reduce the size of the portfolios required, which helps both on the direct earnings front (because banks can devote more investment capital to riskier assets) and relieves some of the squeeze effect on the approved high-quality assets.

In short, banks now have a longer timeline on which to buy a smaller portfolio of an expanded class of high-quality liquid assets. This is definitely good news for the banks.

But is it good news for the rest of us? The final requirements will mean that banks' overall holdings and approved high-quality asset portfolios will be riskier, and the prices paid by the banks for their high-quality liquid assets will be lower than they would have been otherwise. Looked at narrowly, this seems like a giveaway to banks—and perhaps a penalty to taxpayers who are more likely to be called upon to bailout banks under the new rules than the original proposal.

This, however, is too narrow of a view. The expansion of the approved asset classes will ripple through the credit market. Investors who may have piled into the narrower class in anticipation of a squeeze caused by original proposal taking effect in 2015 will see lower returns. Some of these investors are likely to be the largest and healthiest banks, which may now have some regrets that they paid too much for assets included in the narrower class.

One the other hand, the inclusion of corporate bonds all the way down to triple B minus and double A rated residential mortgage securities should drive demand for these assets, driving their prices up and their yields down. This pricing pressure could flow down through the risk-ratings, providing support for things like high-yield securities. The effect should be something like a global credit easing—Q.E. through liquidity requirements.

This is not to say that we should all put on our nightcaps and settle down for a long credit-easing nap. The expansion of the definition of high quality liquid assets will result in a high-level of demand for whatever types of assets have the highest haircut adjusted returns. A highly rated mortgage-backed security has a lower haircut than a similarly rated corporate bond, which will create additional demand for those mortgage-backed securities. Likewise, banks are likely to crowd into the lowest rated corporate bonds included in the bucket to increase the after-haircut yield.

The market is likely to respond to these regulatory driven changes in demand by creating more of these assets. This increase in supply can happen in at least two ways. In the first place, lenders will make more of the preferred loans. That could be a positive for the housing market, although it risks being too positive—possible leading to another credit-driven bubble.

What's more, the market can create more high quality liquid assets by gaming the ratings system—as we saw during the last credit bubble. Banks will seek to put riskier assets into safer categories, putting pressure on the ratings agencies to do the same. The fact that the new rules rely on the judgment of rating agencies—who screwed up royally during the bubble—should be ringing alarm bells around the world, but hardly anyone seems to have noticed.

This brings us to the fat-tail problem with the liquidity coverage ratio. Banks and bank regulators have now agreed on what constitutes a high-quality liquid asset. The entire financial sector will quickly become more exposed to these assets than it would have been otherwise. We will generate more of these assets globally than we would otherwise. If the banks and the regulators are right that these assets are stable enough and liquid enough, then the system should be safer.

But there is good reason to think that the banks and regulators are wrong. For one thing, as Nassim Taleb is constantly warning, the world is less predictable than their models assume, and unexpected changes have significant impacts. How can regulators possibly model the effects on asset quality of increased demand for their favored assets? Can they predict the deterioration of ratings quality? Have they modeled the fact that regulatory-driving pricing creates misinformation about risk?

Which brings us to the overarching problem of financial monoculture . The entire financial system is rendered riskier when all of the largest institutions are cajoled by regulators into adopting a similar view of asset risk—which is exactly what led to our recent financial crisis. The cost of error is greatly increased. Instead of disparate failures, we invite system-wide failure from errors in risk assessment. (Arguably, the expansion of assets included in the liquidity ratio and the lowering of the outflow forecast somewhat reduce the monoculture problem. But only somewhat.) More worrisome still, there is no sign that the Basel folks or the bankers understand the monoculture problem at all.

Neither the bankers nor the regulators understand how our last financial crisis was engineered. Indeed, they seem incapable of anticipating even the highly predictable risks of worldwide financial homogenization outlined above. Which makes it very hard to take seriously their claims that the new rules the regulation peddlers have pulled from their sack will do very much to create a more resilient financial system.

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