Earlier this week, we got a call from someone writing a book – and who isn’t these days – on the financial crisis.  The interview started from an unquestioned premise:  Basel II is to blame for a lot of what befell the global financial system.  This often-unquestioned point is critical, as it is driving much at both the bank regulators and on Capitol Hill.  It’s wrong, though.  Basel II is far from perfect, but it didn’t come into effect in the EU until 2007 and it was only effective to a limited degree for a small number of big U.S. firms before the crash.  What’s most wrong with Basel II is that Basel I lasted far, far too long. 

Basel II was set in motion in the late 1990s because it was clear that financial markets had developed well beyond the simple structure in the initial capital accord.  Most importantly, banks figured out from day-one in 1988 – when Basel I began – that the treatment of off-balance sheet assets was a wide-open invitation to regulatory arbitrage.  The rules then – and now in the U.S. – have no capital charge for any off-balance sheet commitment with a maturity of less than one year.  Shazaam – the world of 364-day commitments was born.  From this came structured investment vehicles (SIVS) and so much else that brought banking to its knees, but nothing about this crisis was in fact unforeseen.  It was just unaddressed. 

Another big problem with Basel I, especially after revisions to it in 2001, was undue reliance on the credit ratings agencies (CRAs).  Basel I turned to the CRAs because it needed someone to rate credit risk for the risk-based regime to work.  CRAs are manifestly flawed and conflicted, but it’s critical to remember that, absent some capital recognition, banks have strong perverse incentives to take lots of risk.   A simple leverage ratio – five percent in the U.S. – is way too low for high-risk assets.  It also makes holding low-risk ones prohibitive from an economic-capital point of view.  Relying on CRAs at the start of the Basel regime was thus a least-worst decision – it provided some insight into risk on what were then thought to be objective grounds in a reasonably- simple way that cured a serious underlying financial-system risk.  

Basel II in fact sought to reckon with the CRA problems by relying more on internal bank models and less on CRAs.  It did this badly, of course, continuing CRA reliance even as complex, untested models were brought to bear on risks no one – least of all the banks – understood. 

This week, we sent clients an in-depth assessment of the latest revisions to Basel II.  Importantly, they force banks – very much against their will – to use their own credit-risk analytics and no longer simply to rely on the CRAs.  CRA determinations remain in the rule as a benchmark for risk-based capital, but just that.  In essence, CRA determinations now are a floor against which banks must make their own credit-risk judgments and hike capital or show why this doesn’t need to be done.  Is this perfect?  Of course not.  Was Basel I better and thus the standard to which regulators should return?  Again, of course not. 

The real poster children for Basel II’s critics are the bulge-bracket U.S. investment banks.  They went on Basel II in 2004 when the SEC rolled over and gave them the consolidated supervised entity (CSE) charter.  When it did so, the investment banks got the gift of a lifetime – an immediate huge reduction in broker-dealer net capital combined with complex capital rules none of them or their regulator understood without the discipline of a leverage standard or – more important still – any SEC prudential or supervisory standards that would ensure Goldman Sachs, Lehmann, et. al. knew what they were doing and in fact did it.   

Is Basel II the cause of the market debacle for the bulge-bracket firms?  One might say so, but this too would be way wrong.  Basel II on its own – without checks, balances or controls – is in fact considerably worse than a simple-minded capital regime like the net- capital rules that preceded them for the investment firms.  But, that isn’t Basel II as it was or, still more important, as it will become now that regulators have sobered up.