Regulatory omissions - the paradox of an oversight body

Note: this blog post was also published at the Adam Smith Institute blog titled: "The paradox of regulation"


Apart from the policymakers in the EU summit, the regulators across Europe are designing their reform proposals on how to improve the financial system and make it more robust to future crises. One of the main proposals on banking regulations in Europe is done by the Basel Committee on Banking Supervision. In addition to Basel I and Basel II, the previous banking reforms that substantially influenced the changes in banking regulation worldwide (I briefly touch upon the Basel Accords in my paper on the crisis) the new proposal, Basel III goes a step further. It is seen as a comprehensive response of the Basel Committee to the financial crisis of 2007-2009.  

The Basel III agenda is based around three key elements aimed at making banks more resilient to future instabilities. Banks need to have core tier one capital equal to 7% of their risk-weighted assets; top “systemically important” institutions need to carry an additional 1 to 2,5% in capital, generating a total of up to 9,5% of top quality capital as part of their risk-weighted assets; the banks need to keep enough liquidity (cash and easy to sell assets) to survive a 30-day crisis.  

The liquidity requirement can actually prove to be quite welcomed, but what will happen after 30 days, and is that time enough for the banks to recuperate and find additional sources of liquidity to cope with the temporary liquidity setback? The current levels of instability in the eurozone seem to be running for three years, and there’s still no sign of recovery.

Disregarding the liquidity requirement, the first two elements of the Basel III regulations are particularly important and can prove to be harmful by setting a trigger for the next big crisis. How so? First of all, can regulators really assess what is tier one capital supposed to be? What are ‘safe’ assets in the eyes of the regulators? In the wake of the current crisis, assets that were considered safe were those backed by the world’s wealthiest governments such as the US, UK and German Treasury bonds, or even better Mortgage-based securities (MBSs) backed by the US Government Sponsored Enterprises (GSEs) (see recourse rule), and sovereign debt of peripheral eurozone countries backed up by all eurozone economies (the peripheral eurozone sovereign debt was assigned the zero risk weight status by Basel I and II).  

All of a sudden, sovereign debt is no longer a safe asset since it could very well lead to the next big depression if all the European banks that hold peripheral debt go bankrupt. The securities that led to the downturn of American financial institutions, MBSs, are also no longer considered safe assets, and are in fact considered “toxic”. However, all of these assets were highly rated (AAA) and government backed making the Basel Committee on Banking institute them as a ‘must have’ for every financial institution. So if they made this mistake before, who is to guarantee that the regulators will pick up good assets now? The regulators can’t and never will be able to anticipate which assets are safe and will stay safe. They always do have the best intentions – keep the system stable, but they don’t have perfect foresight and they don’t posses perfect knowledge of the financial system, no matter how smart they (think they) are.  

Information in the economy is widely dispersed among a huge amount of consumers and businesses which posses local information that enables them to set prices and determine quantities of goods to be bought and sold. The market price aggregating billions of choices and decisions every single day is the best way to express real value. No central regulatory body can do a better job, simply because they cannot physically posses all the necessary information.

The same line of reasoning is applied in the financial market. The complex matrix of information and market participants is somewhat smaller in the financial market and rather global (as the decisions and financial products are run globally) but they are far more complex than regular goods and services and are thus far more difficult to control and have oversight on. Even if the regulators fully understand the complex derivatives and quadrupled securitized loans they cannot process how market participants will react and sometimes cannot even see the obvious consequences of their actions. The current financial crisis is the best example. By steering banks into buying MBSs, they were creating anartificial demand for these securities and henceforth an artificial demand formore mortgages which led banks into lowering their lending standards in order to create more and more AAA-rated MBSs. 

The regulators need to understand the consequences their actions may incur on those being regulated, they need to anticipate their reactions, but have failed to do so continuously. They may fail again, as their desire for finding new safe assets may end up creating another asset bubble. There were some suggestions that the new safe assets should be debt of businesses backed up by government guarantees (in order to have an AAA rating, of course) and re-packaged into new types of securities (see blog post). Others have proposed to do the same with eurozone peripheral sovereign debt – have highly solvent nations pull the debt into securities, back them up the usual way and sell them on the market, thereby creating new, huge, safe bonds and resolve the sovereign debt crisis in one blow. Some banks have already started to issue covered bonds (debt made up of high quality mortgages and loans) backed up by collateral and secured by bank’s other assets in the event of bankruptcy. No matter what the new safe assets look like, by exaggerating their use and forcing banks to fill up their assets with them can only lead to another asset price boom, higher debt burdens (as these safe securities are in fact debt-tied securities) and consequently another recession. 

As far as the impact on the current recovery, an increase of bank capital-asset ratios, even if announced at a future date (in the Basel III case this is 2019), due to negative future expectations will work towards the decrease of lending, unprofitable business lines for banks that will drive costs for bank customers, and finally shift the businesses to seek support on high investment projects with the so-called “shadow banking system” – hedge funds, money market funds, SIVs, and investment funds, the unregulated financial industry. Furthermore, even if we disregard expectations of future contraction by the banks which may lead them to contract today, the European Commission (EC) plans to institute the 9% capital standard as soon as possible to prevent financial contagion from a Greek default (see previous post), making the reaction on the lending market immediate.

The paradox of the regulatory oversight body arises in the following – by striving to make the system stable, they end up increasing the systemic risk and fueling artificial demand that can lead to an asset bubble. By creating incentives to invest in certain types of assets, the regulators send distorted signals about the demand for these assets and hence distort its prices. The effects of their actions are usually counterproductive and the reason this is so is because they think they posses enough data and information to make them control the market economy and the behaviour of market participants. Never was this possible before and has always proved to have disastrous consequences, since the market will always have more information than a few individuals, depicted by the term asymmetry of information. The regulators call upon the asymmetry of information in their desire to overcome it, but they paradoxically become its victims.