OPINION
SEPTEMBER 14, 2010.
Basel's Capital Illusions
The 2008 meltdown was not the result of lax regulation but of abuse of the U.S. financial system by the political class in Washington
By GEORGE MELLOAN
As an achievement in global harmony, the just-announced Basel III agreement rates high marks. Federal Reserve Chairman Ben Bernanke and fellow regulators from the 27 nations that account for most of the world's financing were able to create a common set of banking rules.
The rules themselves are well-intended. By agreeing that all the planet's major financial institutions will be forced to attain a substantially higher level of capitalization, the framers forged a kind of nonaggression pact. If all 27 countries adopt the new rules, no major bank will be able to gain a competitive advantage through loose lending practices. Presto, the world becomes safer from financial meltdowns of the 2008 variety. That's the theory, at least.
There's something to be said for holding banks to higher capital standards, even at the cost of more constrained lending and slower economic growth. But the much-bruited idea that Basel rules will make the world freer of financial crises is highly doubtful, given current political circumstances. The 2008 financial meltdown was not primarily the result of lax regulation but of co-option and abuse of the U.S. financial system by the political class in Washington.
The federal government's "affordable housing" endeavors, beginning in the 1990s, allowed and even forced banks to make highly risky mortgage loans. Those loans were folded into mortgage-backed securities (MBS) sold in vast numbers throughout the world, most promiscuously by two government-sponsored enterprises, Fannie Mae and Freddie Mac.
The Federal Reserve contributed a credit bubble that caused house prices to soar, a classic asset inflation. When the bubble began to deflate in 2007, the bad loans in mortgage securities became poisonous. The MBS market seized up, and financial institutions holding them became illiquid and began to crash. The Lehman Brothers collapse was the biggest shock.
The only way Basel standards might have helped prevent this would have been if they had been applied to Fannie and Freddie as well as to banks. They weren't. President Bill Clinton exempted the two giants from Basel capitalization rules because they were the primary instruments of a federal policy aimed at helping more lower-income people become homeowners. This was a laudable goal that ultimately wrecked the housing and banking industries.
Washington has learned nothing from this debacle, which is why the next financial crisis is likely to have federal policy origins and may come sooner than we think. Fannie and Freddie—now fully controlled by Uncle Sam and exempt from the Dodd-Frank financial "reform" legislation—are still going strong, guaranteeing and restructuring loans while they continue to rack up huge losses for taxpayers. Meanwhile, instead of backing off from such dangerous welfare-state initiatives, the new Obama administration and Pelosi-Reid Congress last year doubled down. Futile "stimulus" spending and union bailouts swelled the deficit, as will ObamaCare. The U.S. Treasury's gross borrowing has been running as high as $1.9 trillion a year to finance a $1.5 trillion federal deficit. Very few economists think the U.S. government can continue to borrow 42% of its vast spending budget, much of it from abroad, without running into trouble.
The reason is that as federal borrowing exhausts the cheap credit available at home and abroad, Washington politicians will likely once again call upon the Federal Reserve to finance Treasury borrowing directly—just as it did for a time after the 2008 crash. The Fed bailed out Fannie and Freddie to the tune of over $1 trillion by buying mortgage securities, and as those securities mature it will free up cash for U.S. bond purchases. But most of the Fed's support for Treasury borrowing will ultimately have to be financed by printing new money. The Fannie-Freddie redemptions will themselves be a drain on the Treasury, adding to its financing needs.
Meanwhile, Mr. Bernanke and his central banking colleagues have forged a new Basel agreement. It is a fine document and may even be incorporated into the banking laws of the signatory nations over the next decade, although there is no certainty of that.
Even so, not everyone is thrilled. Banking analysts are rightly skeptical of new layers of regulation. At the moment the industry is faced with digesting Dodd-Frank (fashioned by Fannie and Freddie's two biggest fans in Congress). The full consequences of this massive law will only be known after its implementation. But it's a safe bet it will raise costs, divert more resources to pointless regulatory compliance and, because of its imprecision and complexity, create a lot more work for lawyers.
The record since the Basel process began 22 years ago doesn't generate faith in banking regulation either. Basel rules didn't prevent the collapse of Japanese banking in 1990, they didn't prevent the 2008 meltdown, and they are not preventing the banking failures that plague the financial system even today. They most certainly will not instill wisdom and a sense of fiscal responsibility in the men and women who design U.S. government spending policies and write the laws that implement them.
A T-shirt slogan of years back read, "Some day, I'm going to get organized." The Basel rule makers, after beavering away once more trying to define such abstruse concepts as strong and weak capital and high versus low risks, obviously hope that they have finally got things right. Given the inherent limitations of any effort to regulate and instill safety into highly complex and variable human transactions, they and we are likely to be disappointed.
Mr. Melloan, a former columnist and deputy editor of the Journal editorial page, is author of "The Great Money Binge: Spending Our Way to Socialism" (Simon & Schuster, 2009).
Copyright 2009 Dow Jones & Company, Inc. All Rights Reserved
The rules themselves are well-intended. By agreeing that all the planet's major financial institutions will be forced to attain a substantially higher level of capitalization, the framers forged a kind of nonaggression pact. If all 27 countries adopt the new rules, no major bank will be able to gain a competitive advantage through loose lending practices. Presto, the world becomes safer from financial meltdowns of the 2008 variety. That's the theory, at least.
There's something to be said for holding banks to higher capital standards, even at the cost of more constrained lending and slower economic growth. But the much-bruited idea that Basel rules will make the world freer of financial crises is highly doubtful, given current political circumstances. The 2008 financial meltdown was not primarily the result of lax regulation but of co-option and abuse of the U.S. financial system by the political class in Washington.
The federal government's "affordable housing" endeavors, beginning in the 1990s, allowed and even forced banks to make highly risky mortgage loans. Those loans were folded into mortgage-backed securities (MBS) sold in vast numbers throughout the world, most promiscuously by two government-sponsored enterprises, Fannie Mae and Freddie Mac.
The Federal Reserve contributed a credit bubble that caused house prices to soar, a classic asset inflation. When the bubble began to deflate in 2007, the bad loans in mortgage securities became poisonous. The MBS market seized up, and financial institutions holding them became illiquid and began to crash. The Lehman Brothers collapse was the biggest shock.
The only way Basel standards might have helped prevent this would have been if they had been applied to Fannie and Freddie as well as to banks. They weren't. President Bill Clinton exempted the two giants from Basel capitalization rules because they were the primary instruments of a federal policy aimed at helping more lower-income people become homeowners. This was a laudable goal that ultimately wrecked the housing and banking industries.
Washington has learned nothing from this debacle, which is why the next financial crisis is likely to have federal policy origins and may come sooner than we think. Fannie and Freddie—now fully controlled by Uncle Sam and exempt from the Dodd-Frank financial "reform" legislation—are still going strong, guaranteeing and restructuring loans while they continue to rack up huge losses for taxpayers. Meanwhile, instead of backing off from such dangerous welfare-state initiatives, the new Obama administration and Pelosi-Reid Congress last year doubled down. Futile "stimulus" spending and union bailouts swelled the deficit, as will ObamaCare. The U.S. Treasury's gross borrowing has been running as high as $1.9 trillion a year to finance a $1.5 trillion federal deficit. Very few economists think the U.S. government can continue to borrow 42% of its vast spending budget, much of it from abroad, without running into trouble.
The reason is that as federal borrowing exhausts the cheap credit available at home and abroad, Washington politicians will likely once again call upon the Federal Reserve to finance Treasury borrowing directly—just as it did for a time after the 2008 crash. The Fed bailed out Fannie and Freddie to the tune of over $1 trillion by buying mortgage securities, and as those securities mature it will free up cash for U.S. bond purchases. But most of the Fed's support for Treasury borrowing will ultimately have to be financed by printing new money. The Fannie-Freddie redemptions will themselves be a drain on the Treasury, adding to its financing needs.
Meanwhile, Mr. Bernanke and his central banking colleagues have forged a new Basel agreement. It is a fine document and may even be incorporated into the banking laws of the signatory nations over the next decade, although there is no certainty of that.
Even so, not everyone is thrilled. Banking analysts are rightly skeptical of new layers of regulation. At the moment the industry is faced with digesting Dodd-Frank (fashioned by Fannie and Freddie's two biggest fans in Congress). The full consequences of this massive law will only be known after its implementation. But it's a safe bet it will raise costs, divert more resources to pointless regulatory compliance and, because of its imprecision and complexity, create a lot more work for lawyers.
The record since the Basel process began 22 years ago doesn't generate faith in banking regulation either. Basel rules didn't prevent the collapse of Japanese banking in 1990, they didn't prevent the 2008 meltdown, and they are not preventing the banking failures that plague the financial system even today. They most certainly will not instill wisdom and a sense of fiscal responsibility in the men and women who design U.S. government spending policies and write the laws that implement them.
A T-shirt slogan of years back read, "Some day, I'm going to get organized." The Basel rule makers, after beavering away once more trying to define such abstruse concepts as strong and weak capital and high versus low risks, obviously hope that they have finally got things right. Given the inherent limitations of any effort to regulate and instill safety into highly complex and variable human transactions, they and we are likely to be disappointed.
Mr. Melloan, a former columnist and deputy editor of the Journal editorial page, is author of "The Great Money Binge: Spending Our Way to Socialism" (Simon & Schuster, 2009).
Copyright 2009 Dow Jones & Company, Inc. All Rights Reserved
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