Overcapitalization Doesn't Compensate for Fragility

Basel III consists of a series of regulations that are meant to provide capital buffers for big banks in the event of a financial crisis. The series consists of three main pillars, which are 1) the net stable funding ratio, 2) the liquidity coverage ratio, and 3) minimum capital requirements. The underlying thesis is for banks to increase their reserves to keep up with updated regulatory capital ratios. Naturally, this entails a corresponding increase in reservable deposits. Banks are left with two choices, to increase their customer deposits, which requires increasing their customer base, or, to invest in government securities. And while banks are focused on increasing reserves as the path of least resistance (and fewer regulatory hurdles), this leads to a decrease in commercial loans. What results is that activity in a bank's lending channel is inhibited. Additionally, it's more costly for banks to make commercial loans, because the Basel III regulation increases banks' cost of capital by 4% in Europe, and 3% in the US. Because of these perverse incentives, banks are pushed to make investments in speculative assets as they seek alternative profit opportunities.

In the last crisis, Basel II had set out leverage ratio requirements that only encompassed on-balance sheet assets. This left out those instruments that were off-balance sheet. Following the law of negative incentives, banks invested their excess reserves in derivatives such as CLO's backed by corporate junk rated leveraged loans. Despite highly speculative behavior, the big banks looked better capitalized than they really were.

This time around, Basel III has amended leverage ratio requirements to encompass off-balance sheet items. The problem this time around isn't about what you don't see. It's about what's there directly in front of you. As discussed in previous articles, large banks, especially in Europe, have been loading up on sovereign bonds to better capitalize themselves. These sovereign exposures have been assigned 0% risk weightings, essentially deeming them "risk-free."

This induces banks to load up on domestic sovereign bonds without needing them to raise more capital, because they're done at no cost to banks. Being "risk-free," sovereign bonds are considered the safest form of collateral in many financial transactions, from derivative contracts to repos. It's no wonder that they're so commonly used. And, because sovereign bonds are considered a liquid asset, according to Basel III's liquidity capital ratios, banks are overcapitalized. Of course, an asset is only as safe as the financial discretion of its issuer. As countries like Italy struggle under their debt burden, and the implications of interest rate suppression play out, it doesn't matter how overcapitalized a bank is. It's the underlying quality of the assets on its balance sheet that matters most.




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