Banking: Basel III fails to address root cause of global financial crisis

It beggars belief that Basel III, driven by the USA, has missed the point. Focussing on the high-profile failures of financial institutions which traded in derivatives, it has entirely failed to take account of the root causes of those failures.

In doing so, it is doing the equivalent of delivering topical treatment to sores whilst ignoring the underlying disease.

At the heart of the global financial crisis was that US banks did not properly risk assess and manage lending.

The fundamental reasons behind that were that the US Fed, under Alan Greenspan, presided over an uncontrolled expansion of consumer credit a high proportion of which was in home loans.

That expansion of consumer credit, as any first year economics student knows, leads to inflation.

As the Fed drove interest rates down - in order to raise short-term consumer confidence and sentiment - the structure of domestic mortgages in the form of low-start loans - US home buyers bought into the dream of their own house with a garden.

Fear drove people to get "onto the property ladder" - a symptom well documented in the UK's housing gold-rush of the mid-1980s - and its subsequent crash - an event which, by Greenspan's own admission, was not factored into the Fed's economic models.

Those who already owned their own home saw the next rung on the ladder moving out of reach and jumped before the step became too great to bridge.

Compounded by self-certification mortgages - again a core cause of the UK's crash almost two decades earlier - the opportunity for fraudulently obtained loans was rife. The applicants did not, in most cases, consider it a fraud: they were sold a dream - if they bought their home then inflation in the value of that asset would take care of them and, in any case, general inflation would see salaries rise.

That did not happen but still the Fed did not undertake a proper risk assessment of lending practices - instead Greenspan issued a mild warning that banks should not over-reach themselves in a rapidly rising housing market. He did not say "this is a bubble, bubbles burst and asset values collapse."

The failure in the US domestic mortgage market was as inevitable as it was predictable. The only question was when it would happen.

In October 2006, the data showed it was already happening: repossession rates were climbing dramatically. And still the Fed promoted expansion in consumer credit.

Less than a year later, the market took care of that as banks refused to lend to each other as their inter-bank risk assessments began to show up anomalies which rapidly turned lending decisions on their head: from "show me a reason not to make this loan" banks started to say "show me a reason that this loan is secure."

Underpinning all of this was a simple decision by the Fed: it exempted the vast majority of US banks from compliance with Basel II. In short, not only were those less-than-large banks that operated entirely domestically (in the sense of having no offshore branches or subsidiaries) not required to undertake the same stringent risk assessment with regard to credit risk as large or internationally active banks but they did not have to maintain similar capital adequacy levels.

And even now they don't. In the past two years, more than 250 local banks have collapsed. The vast majority are small banks - some are absolutely tiny. The most striking feature of the collapsed banks is that almost all of them have an almost equal balance between "assets" and "deposits." Under Basel II, that would not have been possible.

In Nigeria where, less than a decade ago, there were some 900 banks in a similar deposit/asset ratio position, regulators forced consolidation: now there are a dozen national banks. The approach was to impose something akin to Basel II on all banks: by making substantial increases in the required capital adequacy ratio, regulators forced mergers and takeovers. None of the small banks failed during that process although two failed to find suitors and were wound up - with all depositors being paid in full.

The USA on the other hand, with almost 9,000 banks regulated by FDIC, the deposit guarantee scheme, made no such demands on its small banks.

And Basel III will not require the USA - or any other country - to address these fundamental failings. And the USA is pleased about that, enshrining as it does, the USA's effective opt-outs under Basel II.

"The U.S. federal banking agencies support and endorse the efforts of the GHOS and the Basel Committee to strengthen the capital position of large and internationally active banks." it says in a statement issued by the Fed, OCC and FDIC on 10th September.

It goes on to show that this approach is also confirmed in domestic policy - in advance of Basel III "

The Dodd-Frank Wall Street Reform and Consumer Protection Act requires the establishment of more stringent prudential standards, including higher capital and liquidity requirements for large, interconnected financial institutions."

And in a nod to the Bank of International Settlements it says "the Basel Committee continues work on the development of measures to improve the loss absorbing capacity for systemically important financial institutions."

But it was not the "systemically important financial institutions" - those which are "too big to fail" that produced the underlying assets with - let's be polite - optimistic valuations which were ultimately bundled and sold on as "asset backed securities," a device which, incidentally, Greenspan specifically endorsed as good for the financial sector in 2002.

For sure, the new provisions are expressed to be "

designed to give institutions the opportunity to implement the new prudential standards gradually over time, thus alleviating the potential for associated short-term pressures on the cost and availability of credit to households and businesses."

But, as with the USA's implementation of Basel II, only the "large and internationally active banks" are included.

The measures may help reduce contagion in the event of another domestic crisis but they do nothing to prevent another housing bubble and mass bank failures amongst domestic banks.

And even now, the official US government line, from the President down, is that consumer credit must be expanded to fix the recession.

Plus ça change, plus la même chose.

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Nigel Morris-Cotterill is Head, The Anti Money Laundering Network, ultimate holding company of BankingInsuranceSecurities.Com