Markets Insight

December 12, 2012 11:55 am
 
Get Basel III right and avoid Basel IV
 
We must insist on strong capital for all banks




As the world struggles to address the urgent need to have stronger capital standards for banks, I am reminded of a Midwestern saying I heard often as a young man: “You never seem to have time to do it right the first time, but you always seem to have time to do it over.” It is a maxim we should keep in mind when we hear chief executives and regulators around the globe say that Basel III needs to be accepted and implemented quickly to assure a better capitalised and safer financial system. Rather than pushing through a flawed Basel III, we need to take the time to do it right so we do not have to do it over.




Each new Basel standard attempts to correct the errors and unintended consequences of earlier versions. But instead of resulting in better outcomes, each do-over has been more complicated and less effective than the last. Most disturbingly, each fails to provide enough real capital to absorb unexpected shocks to the economy.




The many Basel iterations all rely heavily on econometric models and probability estimates that are precise to a decimal point. They attempt to estimate the riskiness of assets on a scale of very high to none. Using this system of risk-weighted assets, the 10 largest US banking groups had total Basel capital to risk-weighted assets averaging 11 per cent in 2007 at the start of the financial crisis. The chief executives of these banks were confident, even boastful, of being well capitalised.




But using tangible equity capital and total assets – a more conservative, more credible method of assessing capital adequacy – the average leverage ratio of those same US banks was only 2.8 per cent prior to the crisis, or less than three cents for every dollar of assets on the balance sheet. This more conservative calculation reflects what good analysts do: it excludes items that do not absorb losses in a crisis, such as goodwill, deferred tax assets and other intangibles. And it includes all assets, including those thought to be risk-free.




Once again, in an effort to remedy the flaws of earlier versions, Basel III is meant to increase the quantity and quality of capital on the balance sheet. Some remain confident that Basel III accurately assigns risk weights to numerous categories of assets.



Unfortunately, the weightings are more arcane than ever and, therefore, even less useful. Despite the promise of higher capital levels and better quality capital, Basel’s new minimum leverage ratio requirement is only 3 per cent, about the same as that of the largest US banks when the global crisis erupted. Basel III offers more complexity and, therefore, new opportunities to circumvent the system. But it does not offer any more certainty that banks will be well capitalised when the next crisis hits.




In considering the issue of stronger capital, the following comparison is useful. Using the mid-year 2012 regulatory reports for the 10 largest bank holding companies in the US, the average tangible equity capital ratio is only 6.1 per cent and the highest is 7.9 per cent. Importantly also, few of the largest banks outside the US have tangible equity capital ratios greater than those of the largest US banks, even after adjusting for differences between US and international accounting standards. Two global megabanks even have ratios of less than 2 per cent.




These are not sufficient levels of capital by any measure, particularly given what we know from the global financial crisis. Some countries are pushing hard to embrace Basel III while claiming it will result in better and higher capital, but it will not. Many of the largest internationally active banks will not sufficiently increase their tangible equity capital under Basel III.




So what level would be sufficient? Before deposit insurance was introduced, the tangible equity capital ratios for US banks of all sizes averaged above 10 per cent.




Depositors insisted on these levels if they were to trust the bank with their money. Now, instead of capital, the public relies on deposit insurance for protection, leaving other banks and taxpayers to backstop a failed financial institution.



To protect well-run banks, to protect the taxpayer and to ensure that an economy has access to reliable credit, we should insist on strong capital for all banks.




We can establish a simple but stronger capital base by replacing the unmanageably complex Basel risk-weighted standards with a tangible equity capital ratio of around 10 per cent, and use a simplified risk-weighted measure as a check against excessive off-balance sheet assets or other factors that might influence banks’ safety.




If the financial industry had had tangible equity capital approaching this level in 2008, we might still have had a crisis. But it would have been far less severe and far less costly to the public.




Basel III’s implementation has been postponed, and that offers a real chance to get it right. If we do, we won’t need Basel IV.




Thomas M. Hoenig is the vice-chairman of the Federal Deposit Insurance Corporation


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Copyright The Financial Times Limited 2012.



East Asia’s Turning Point

Brahma Chellaney

12 December 2012
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NEW DELHI Political transitions in East Asia promise to mark a defining moment in the region’s jittery geopolitics. After the ascension in China of Xi Jinping, regarded by the People’s Liberation Army (PLA) as its own man, Japan seems set to swing to the right in its impending election – an outcome likely to fuel nationalist passion on both sides of the Sino-Japanese rivalry.



 
Japan’s expected rightward turn comes more than three years after voters put the left-leaning Democratic Party of Japan (DPJ) in power. By contrast, South Korea’s electionscheduled for December 19, just three days after the Japanese go to the polls – could take that country to the left, after the nearly five-year rule of rightist President Lee Myung-bak, who proved to be a polarizing leader.
 
 
 
 
These political transitions could compound East Asia’s challenges, which include the need to institute a regional balance of power and dispense with historical baggage that weighs down interstate relationships, particularly among China, Japan, and South Korea. Booming trade in the region has failed to mute or moderate territorial and other disputes; on the contrary, it has only sharpened regional geopolitics and unleashed high-stakes brinkmanship. Economic interdependence cannot deliver regional stability unless rival states undertake genuine efforts to mend their political relations.
 
 
 
 
The scandals surrounding the top aides to Lee nicknamed “the Bulldozer” from his career as a construction industry executive – have complicated matters for the ruling Saenuri Party’s candidate, Park Geun-hye, and buoyed the hopes of her leftist rival, Moon Jae-in of the Democratic United Party. Park is the daughter of former president, General Park Chung-hee, who seized power in a military coup in 1961.
 
 
 
 
Reining in South Korea’s powerful chaebol (family-run conglomerates) has become a key issue in the presidential election, with even Park favoring tighter control over them, although it was her father’s regime that helped build them with generous government support. Her populist stance on the chaebol suggests that, if elected, she might similarly pander to nationalist sentiment by taking a tough stance against Japan, especially to play down her father’s service in Japan’s military while Korea was under Japanese colonial rule.
 
 
 
But, even if Moon becomes president, the new strains in South Korea’s relationship with Japan, owing to the revival of historical issues, may not be easy to mend. Earlier this year, Lee, at the last minute, canceled the scheduled signing of the “General Security of Military Information Agreement” with Japan, which would have established military intelligence-sharing between the two countries, both US allies, for the first time. Lee also scrapped a bilateral plan to finalize a military-related Acquisition and Cross-Servicing Agreement. Weeks later, he provocatively visited the contested islets known as the Dokdo Islands in South Korea (which controls them) and the Takeshima Islands in Japan.
 
 
 
China, meanwhile, has cast a long shadow over the Japanese parliamentary elections. In recent months, China has launched a new war of attrition by sending patrol ships frequently to the waters around the Japanese-controlled Senkaku islands, which China calls Diaoyu. This physical assertiveness followed often-violent anti-Japanese protests in China in September, while a continuing informal boycott of Japanese goods has led to a sharp fall in Japan’s exports to China, raising the risk of another Japanese recession.
 
 
 
 
The DPJ’s 2009 election victory had been expected to lead to a noticeable warming of Japan’s ties with China. After all, the DPJ came to power on a promise to balance Japan’s dependence on the US with closer ties with the People’s Republic. But its bridge-building agenda foundered on growing Chinese assertiveness, leading successive DPJ governments to bolster Japan’s security ties with the US.
 
 
 
 
China’s behavior has fueled a nationalist backlash in Japan, helping to turn hawkish, marginal politicians like Shintaro Ishihara into important mainstream figures. Japan may be in economic decline, but it is rising politically. Indeed, Albert del Rosario, the foreign minister of the Philippines, which was under Japanese occupation during WWII, now strongly supports a re-armed Japan as a counterweight to China.
 
 
 
 
But the resurgence of nationalism in Japan is only fanning Chinese nationalism, creating a vicious circle from which the two countries are finding it difficult to escape. Shinzo Abe of the Liberal Democratic Party, who is likely to become Japan’s next prime minister, has vowed to take a tougher line on Senkaku and other disputes with China. More important, the LDP has called for revising Article 9 of Japan’s US-imposed post-1945 constitution, which renounces war.
 
 
 
 
The risks posed by increasing nationalism and militarism to regional peace have already been highlighted by the rise of a new Chinese dynasty of “princelings,” or sons of revolutionary heroes who have widespread contacts in the military. The real winner from the recent appointment of the conservative-dominated, seven-member Politburo Standing Committee is the PLA, whose rising clout has underpinned China’s increasingly assertive foreign policy.
 
 
 
 
 
In fact, what distinguishes Xi from China’s other civilian leaders is his strong relationship with the PLA. As Xi rose through the Communist Party ranks, he forged close military ties as a reservist, assuming leadership of a provincial garrison and serving as a key aide to a defense minister. His wife, Peng Liyuan, is also linked to the military, having served as a civilian member of the army’s musical troupe, and carries an honorary rank of general.
 
 
 
 
 
Against this background, the central challenge for East Asia’s major economies – particularly Japan and South Korea – is to resolve the historical issues that are preventing them from charting a more stable and prosperous future. As a Russian proverb warns, “Forget the past and lose an eye; dwell on the past and lose both eyes.”
 
 
 

Brahma Chellaney, Professor of Strategic Studies at the New Delhi-based Center for Policy Research, is the author of Asian Juggernaut and Water: Asia’s New Battleground.



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Copyright Project Syndicate - www.project-syndicate.org


HEARD ON THE STREET
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Updated December 12, 2012, 6:33 p.m. ET
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Fed Chooses a New Job Description
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By JUSTIN LAHART

 
 
 

Most central banks are guided by a deep fear of inflation. Not the Federal Reserve, not anymore.


 
The Fed's dual mandate, established in the late 1970s, tasks it with keeping prices stable while keeping employment as high as possible. But for most of that time, it was prices that the Fed focused on, with the central bank focused on when to take away the "punch bowl."



A review of Fed meeting minutes, congressional testimony and policy statements conducted by St. Louis Federal Reserve economist Daniel Thornton shows that the central bank rarely broached the subject of maximum employment until the 2008 financial crisis struck.



But since then, the Fed has become increasingly focused on employment. Wednesday, it codified it, saying that it will keep rates near zero as long as the unemployment rate is above 6.5%, provided its projections for the inflation rate one and two years out aren't above 2.5%. And it will keep on buying mortgage-backed securities absent signs the job market is improving.



In other words, its actions will principally depend on a firm number, the unemployment rate, tempered by what happens to much squishier estimates about what inflation might be in the future.



In some regards, the Fed's new wording doesn't change anything. When it met in October, it said that it expected to keep rates near zero through mid-2015, and its latest projections show that Fed board members and regional bank presidents, on average, expect unemployment to fall below 6.5% sometime in 2015.




But while the change binds the Fed more firmly to what happens to the unemployment rate, it also adds some flexibility to the timing of future shifts in monetary policy. If, say, the job market improves faster than Fed officials now forecast, they will tighten sooner than 2015.




The theory behind this is that when short-term rates are near zero, putting in a specific rules-based framework for what must occur before they are raised can help to keep long-term interest rates lower for longer.




The Fed has left itself some wiggle room in how it proceeds, with Chairman Ben Bernanke specifying Wednesday that if the unemployment rate falls below 6.5% but inflation forecasts remain quiescent, the Fed might not raise rates. But the central bank has never prescribed what its future actions will be to such a detailed degree before.



The danger is that the Fed puts together inflation projections that are too rosy. Right now, the risk of that happening doesn't look that high. Inflation trends tend to change slowly, to the extent that the best way to forecast what the change in core prices will be over the next year is generally to look at the past year.



But on the off chance that the Fed does get badly surprised by rising inflation, it will have to go from an incredibly loose monetary policy to a much tighter one in an awfully big hurry.



December 11, 2012 5:39 pm
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Japan should scare the eurozone
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By Sebastian Mallaby
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Europe risks replicating Japan’s lost decades.

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Ingram Pinn illustration




Almost exactly 20 years ago I packed my stuff in London and moved to Japan. The Tokyo stock market had crashed some two years previously; the property market was in free fall; lenders that had relied on buildings as collateral were gasping for air. Yet the country was in denial about its problems. Nobody imagined that Japan would today be suffering its fifth recession in two decades.



The question is whether Europe is walking the same path. As in Tokyo in the early 1990s, eurozone policy makers believe they are doing as much as politics allows.
 


As in Tokyo, financial markets lull them with periods of calm. And yet, also as in Tokyo, fiscal and monetary policy preclude escape-velocity growth in the short term; structural reform is insufficient to deliver reasonable growth in the medium term; and the authorities underestimate the twin challenges of debt and demography in the long run.



The initial shock that Europeans have experienced is more severe than Japan’s. In the four years after the crash in early 1990 Japan’s economy actually grew by a total of 5 per cent. In the four years since the Lehman Brothers bankruptcy the eurozone has shrunk 1.5 per cent. Four years into the crisis, Japan’s equity implosion looked similar to what has befallen peripheral Europe, but its house prices had fallen less than Spain’s or Ireland’s.



In the early phase of the crisis, Europe’s policy response was superior. Starting in October 2008, the European Central Bank cut short-term interest rates by 3.25 percentage points in seven months; the Bank of Japan took 20 months to cut by that amount. Europe’s fiscal policy was also more aggressive: the total eurozone government deficit grew 4.3 percentage points in the first year of the crisis, whereas it shrank slightly in Japan.




 
 
  
But four years after the shock, Europe does not emerge as well from these comparisons. Where Japan’s policy makers retained some ammunition, Europe’s can no longer cut short-term interest rates significantly, and seem unwilling to contemplate full-blown quantitative easing.



Austerity measures, meanwhile, coupled with a refusal to issue eurozone bonds, have saddled the region with a fiscal policy that is less supportive than Japan’s was at the same point.



What of structural reform? In the real economy Japan’s painfully slow progress on deregulating the retail sector resembles Europe’s mixed record. Italy has half-modernised its labour law, half-reformed its energy market, and half-deregulated its cosseted professions.



In the financial sector, Japan’s enormous error was to wait eight years before recapitalising banks with public money, allowing an extended period in which promising companies were starved of loans. The eurozone is getting to this problem after four years, thereby limiting itself to a medium-sized error. But Europe’s banks will not be truly healthy until they are clear about their regulatory future, which means resolving arguments over banking union. This week’s EU summit is unlikely to do that.



A huge initial shock; macroeconomic policy nearing exhaustion; and messy progress on structural reform: could things be worse? Yes, is the answer. Whereas Japan went into its crisis with a low public debt ratio, peripheral Europe started out slightly worse (in the case of Ireland and Spain) or far worse (Portugal, Italy, Greece). And although Japan’s demographic bust is rightly notorioussales of nappies for adults now exceed those for infants – the outlook in peripheral Europe is bad enough to be frightening. In a 2010 study, Richard Jackson of the Center for Strategic and International Studies combined demographics and welfare promises into a “fiscal sustainability index”. Italy, Spain, France and even the Netherlands fared worse than Japan.



Some observers draw comfort from the fact that Japan’s public debt has grown Godzilla-sized without causing disruption. Perhaps the eurozone can allow itself a debt Obelix without paying a high price? It is true, as Martin Wolf argues, that balance-sheet recessions are followed by extended periods in which companies and households pay down debt rather than borrow, with the result that governments can borrow cheaply and huge public debts appear affordable.
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But this is not altogether comforting. Once balance sheets are rebuilt, rising private credit demand will push up interest rates for the government – a punishment that peripheral Europe would feel quickly, given that the average public debt maturity is in the region of only six years. The alternative is that the balance-sheet slump endures indefinitely. Japan’s two consecutive lost decades are precisely what Europe should not want to emulate.



But the scariest lessons from a Japan-eurozone comparison are social and political. For better or worse Japan has a homogenous society and placid politics; the Liberal Democratic party, architect of the bubble that laid waste to the economy, heads into next Sunday’s election as clear favourite.



Japan’s cohesion is both reflected in and protected by surprisingly low official unemployment, which has never risen above 5.4 per cent in the past 30 years. Contrast that with Spain or Greece, where unemployment stands at about 25 per cent, or France or Italy, where it stands at 11 per cent. Add in riots and demonstrations across Europe, and you begin to wonder how the centre can hold.



The writer is a senior fellow at the Council on Foreign Relations and an FT contributing editor



The Financial Times Limited 2012.