Basel III: regulators seem to ignore market failures

The changes in our regulatory framework (BASEL 3) and the widespread use of inappropriate IFRS rules will not solve the imbalances of the international financial and economic system. Quite the opposite, regulators should instead focus their attention on dysfunctions and irrationalities in financial markets

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This article complements and extends a recent paper entitled "Reconciling bank processing and prudential regulation"

I do not usually view any attempt to regulate as a threat on banks integrity; I do rather think that the regulator reacts almost always too late and does not understand enough the banking operational issues. It is now clear today (always easy to say after) that upcoming Basel 3 regulatory framework could and should have been a perfect cure for 2003-2007 market conditions (low risk aversion and low risk reward with ridiculously low credit spreads for several corporate and banks).

And so it is now that we set up some shifted regulatory changes which may be completely inappropriate to the next 5-10 years economic situation: increasing competition between private and public issuers, strong rebalancing of international capital flows with a progressive reduction of the surplus savings in emerging countries. Here is a regulatory framework designed in 2008-2011 that will be applied to the 2013-2020 economic context with most probably a different referential, unlike the 2003-2007 period. Unbelievable!

The regulator must therefore not focus primarily on features that will complicate even more the financing of economies. Because very objectively, the Basel 3 rules will inevitably make the financing more difficult. Some studies estimate that the transition from Basel 2 to Basel 3 will nearly force banks to double stockholders’ equity. What impact on the rise of cost of resources? Assuming that the average weight of equity in total liabilities of banks is around 8% and the cost of equity is always around a ROE (return on equity) of 15%, the increase in liabilities cost relative to the balance sheet would be about 120 basis points (8% x 15%). Credits accounting for about 50% of bank assets, we would therefore require an increase of about 240 basis points of loans interest rate (50% of 240 bp corresponding to the 120 bp increase in the cost of resource) to neutralize the negative effects of Basel 3 on banks’ liabilities

What we expect regulators to do is rather to correct the irrational behavior and pricing of financial markets, with all the negative consequences it can have on the real economy

Two major types of irrationalities are often observed:

  • First sustained deviations of asset prices relative to fundamentals with destabilizing consequences for the economy: excessive variability of demand with wealth effects; high debt levels followed by solvency crisis; abnormal changes in competitiveness conditions; crises in emerging countries with foreign currency debt, inefficient allocation of savings.
  • Second, what are called self-fulfilling prophecies. The transition from a financial and economic equilibrium to another is not necessarily linked to the transformation of the economic environment but more to changes in anticipations. We have seen several examples of self-fulfilling prophecies in recent years:
    • example 1 Conclusion on banks’ health: with Lehman’s bankruptcy, a conviction that all banks may disappear and that states will not recapitalize, resulting in the halt of interbank transactions, the contraction in bank lending, falling demand and falling assets’ prices, and finally threats on banks solvency;
    • example 2 financial markets liquidity : if investors believe that there will be no buyers in the future for a particular financial asset, they will simply stop buying, the markets will turn illiquid and asset prices will collapse, as initially anticipated - wrongly or rightly - by investors themselves;
    • example 3 sovereign debt crisis in euro zone’s peripheral countries raised the idea of the possibility of default of a sovereign borrower in the euro area (not always unjustified from a fundamental point of view). The issue here is that this type of anticipation is often self-fulfilling as it leads to a rising interest rates on debt and thus raises issues on debt sustainability

What can and must do regulators. We suggest four types of changes whose main objectives would allow:
-individual and institutional investors to manage serenely their long-term savings
-institutional investors and treasurers to hedge their risks in reasonable market price conditions
-less economic variability (caused by the aberrations of market fluctuations, with unjustified wealth effects at the household level)
-a healthy "de-financialization " of the economy
-a reduction of systemic risk

First necessary evolution. Regulators should ensure that investors are not buying financial assets at substantially high prices.
This is indeed one of the most sensitive issue given the fact that purchase, by financial intermediaries, of assets at a very high price strengthens the overvaluation of these assets and bubbles, and moreover, an abrupt change in prices might lead to players’ solvency issues. This requires, in particular, a real control of world money creation (the exact opposite is happening today with the FED quantitative easing and Asian central banks’ intervention on foreign exchange)

Second necessary evolution. we must reduce the destabilizing effect of changes in prices of some assets on the economy. This implies a cons-revolution in accounting standards (reverse IFRS) with the waiving of mark to market for certain types of financial instruments and certain types of financial market participants

Third necessary evolution. We must impose limits on the weight of some assets in given portfolios (for example introducing capital consumption penalization). After all, the speculative positions, that are not related to fundamentals and destabilizing market prices, are not only linked to a macroeconomic environment of high money creation and thus excess of liquidity; but also linked to the shortcomings of capital requirements on some market positions.

Fourth necessary evolution. Surprising as it may seem, regulators must be able to know exhaustively detailed structure of investors portfolios (and especially understand it). Furthermore, they should have a right vision of what are roughly "normal" prices for some financial assets (markets are not doing better on this specific topic, especially with the sustainable and tremendous valuation errors on some financial assets in recent years)

  • Thus, some assets actually designed to be held for long-term should not be valued in continuous time (one should think of other types of valuation) for the benefit of long-term investors.
  • Moreover, some streaming valuations can also be legitimately questioned, mainly for illiquid assets or those precisely designed to be carried to completion; Otherwise we will continue to see glaring anomalies on some financial assets valuation and strong disturbances on markets
Mory Doré March 2011

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