Monday, May 10, 2010

European Bank Bailout

The NY Times reports what may be the key part of the rescue package that is now rallying the markets: a bank bailout. "The European Central Bank reversed its position of just a few days ago and began buying government and corporate debt."

Why did the prospect of defaulting Greek government bonds--like the prospect in 2007-8 of underperforming AAA-rated mortgage-backed securities--cause a *banking* crisis? Because banks held so many of these securities. Why did they do that? In part, at least, because of banking regulations.

Under Basel I, banks received 100 percent capital relief for off-balance-sheet holdings of bonds purchased in short-term commercial paper markets with funds borrowed from money market funds, which are required by law to invest in AAA bonds.

Under the Recourse amendment to Basel I, enacted in the U.S. only in 2001 and implemented 1/1/2002, AA or AAA rated asset-backed securities received a 20 percent risk weight, meaning that $100 in ABS, such as MBS, could be bought using only $1.60 of capital: 8 percent regulatory capital minimum x .20 = 1.60. In comparison, whole (individual) mortgages were risk weighted at .50, requiring 60 percent more capital: $4 in capital to lend $100 in mortgages. And business loans and commercial bonds were risk weighted 100 percent, requiring $8 in capital per $100 in business loans.

Could that be why economic growth was comparatively slow in the 2000s, outside the housing sector?

Under Basel II, implemented outside the United States in 2006-7, the regulators favored highly rated sovereign debt. For the exact risk weights of Greek, Portugese, Spanish, and Italian government bonds, see yesterday's post here.

However, yesterday's reporting probably underestimated the amount of Greek sovereign debt in European banks' hands--$140 billion in sovereign plus private debt, according to today's WSJ, which has a good analysis of the role of the Basel rules in encouraging these bank holdings.

One might argue that banks would have bought sovereign debt anyway, for all the usual reasons one might buy any bonds. Yep, and the same is true of mortgage-backed securities, which were bought by many institutional investors that weren't covered by the Basel or Recourse rules. However, it would be ludicrous to think that the regulations therefore had no effect. The effect was to *magnify the quantity* of these particular assets that were purchased by commercial banks.

The purpose of regulation is to push behavior in the direction desired by the regulators. Purchases of AAA-rated MBS and of variously rated sovereign debt were *not* just governed by the usual considerations. Also weighing heavily on the scale were the financial inducements that the Basel rules provided for leveraging into "safe" assets, as defined by the Basel Committee on Banking Supervision. This is presumably why only banks, as a class of institutional investor, were nearly wiped out by their MBS holdings in 2008, and why banks needed to be bailed out last night.

It is thus misleading to argue, as do Johnson & Kwak and the few other economists who have discussed the Basel rules, that banks "exploited a loophole" by buying assets with low risk weights. Banks that did this were doing *exactly* what regulators wanted them to do: they were leveraging into securities that the regulators judged safe. Unfortunately, in both cases, the regulators' judgments were wrong.

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