How Regulators Herded Banks Into Trouble

Click here to read this article by Peter Wallison in today's WSJ. The subtitle is: "Blame the Basel capital standards for over-investment in mortgage-backed securities and now government debt." Excerpts:

"In the U.S., this shock came when the 10-year housing bubble deflated and U.S. financial institutions were weakened by a sudden loss in value of the mortgage-backed securities (MBS) they were holding, especially those based on subprime mortgages. Mark-to-market accounting did the rest, requiring banks to write down the value of their MBS assets until they appeared unstable or insolvent.

In Europe, the problem is similar and so is its source. Europe's banks, like those in the U.S. and other developed countries, function under a global regulatory regime known as the Basel bank capital standards."

"the Basel rules require commercial banks to hold a specified amount of capital against certain kinds of assets."

"Under these rules, banks and investment banks were required to hold 8% capital against corporate loans, 4% against mortgages and 1.6% against mortgage-backed securities."

"these rules are intended to match capital requirements with the risk associated with each of these asset types, the match is very rough. Thus, financial institutions subject to the rules had substantially lower capital requirements for holding mortgage-backed securities than for holding corporate debt, even though we now know that the risks of MBS were greater, in some cases, than loans to companies. In other words, the U.S. financial crisis was made substantially worse because banks and other financial institutions were encouraged by the Basel rules to hold the very assets—mortgage-backed securities—that collapsed in value when the U.S. housing bubble deflated in 2007."

"Today's European crisis illustrates the problem even more dramatically. Under the Basel rules, sovereign debt—even the debt of countries with weak economies such as Greece and Italy—is accorded a zero risk-weight."

"In the U.S. and Europe, governments and bank supervisors are reluctant to acknowledge that their political decisions—such as mandating a zero risk-weight for all sovereign debt, or favoring mortgages and mortgage-backed securities over corporate debt—have created the conditions for common shocks.

But that is not all that can be laid at the door of regulators. Examiners and supervisors operating "by the book" tend to disregard the judgments of bank managements in favor of regulator-approved methods of assessing credits and carrying reserves. As banks begin to conform to regulator preferences, natural diversification declines and all banks start to look pretty much alike. Then, like genetically altered plants, they are vulnerable to a pathogen—like MBS backed by subprime mortgages—that sweeps through the population."