How Basel III Rules Augment Systemic Risk

Even if its goals are laudable, a tough regulation always generates perverse effects. Such is the case with Basel III, and it’s a shame, because it’s the solidity of our banks that is concerned.
 

Fitch, the rating agency, just published an article that sheds some light on those distortions. By aiming to limit the amount of risk the banks can take, Basel III rules apply a ratio to each type of asset. For real estate loans to individuals, banks must keep a certain percentage of the total amount in liquidities, for credit to businesses, another percentage and so forth. The intention behind the rules is to force the banks to keep a cushion of liquidities in case of a crisis or a change in economic circumstances.

Very well. But, with sovereign bonds from the Eurozone being considered as safe, banks do not have to freeze any cash as counterparty to their agreements. We’re witnessing here the results of the lobbying of the States, which must find buyers for their growing debt. But the consequence is that it’s much less costly for the banks to invest in sovereign debt than it is  to buy stocks or make some loans, because there is no need to hold any liquidity for them!

Fitch has measured the effects of these rules since their inception in December of 2010. Since that date, the 16 most important european banks, the G-SIBs, or « global systematically-important banks », have raised their exposure to sovereign debt by 26%, to reach 550 Billion euros. At the same time, they have reduced their stock holdings by 9%, to 440 Billion euros. Business loans have dropped by 9%, to 275 Billion euros. Real estate loans are the only ones to have risen in that period, by 12%, to 275 Billion euros.

This is really a tragic evolution : Banks are getting out of productive investments (business loans and stock market) and into State financing and real estate. And, after having provoked this state of affairs behind the curtains, political leaders are complaining about the absence of economic recovery!

But the main risk is more systemic risk for the financial system, even though the intention was to have less! With banks holding more and more sovereign debt, if either the country or the bank falls, the other one falls as well. If a country (let’s say Italy, or Spain) must restructure its debt, its banks will fail. And each of those banks is « systemic », meaning its default would impact the whole european financial system...

This goes to show, in any case, that the Basel III rules are not bringing an answer to the actual financial crisis... they’re actually making it worse. This is smokescreen politics at best.