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Doubts cast over Basel II ‘safety net’

By Damian Paletta and Alistair Macdonald



Some of the world’s top banking brains spent nearly a decade designing new rules to help global financial institutions stay out of trouble. What if much of their thinking was wrong?


A version of their new guidelines – known as Basel II after the Swiss city where they were crafted – was about to be phased in next month in the US. Their primary tenet: banks should be given more freedom to decide for themselves how much financial risk they should take on, since they are in a better position than regulators to make that call.


But the global financial turmoil triggered by the popping of the American housing bubble is upending fundamental assumptions about risk. Institutions worldwide have badly misjudged the safety of investments ranging from sub-prime mortgages to complex structured financial securities. This is especially true in Europe, where many banks are operating under the new Basel II risk standards.
In one early bad omen, Britain late last year suffered its first bank run since 1866, when mortgage lender Northern Rock was caught off guard when credit markets froze around the world during the crises.


Applying Basel II’s tenets, Northern Rock a few months earlier announced it would boost its shareholder dividend by 30 per cent – a move that would cut into its capital even as regulators began worrying about the firm’s condition. Last month the British Government nationalised Northern Rock.


Even in Switzerland, home to the new Basel rules, bankers have been burned on bad bets. UBS wrote down $18 billion (Dh66bn) in losses due to flaws in the way the bank managed its own risk. (The firm was not operating under Basel II-style rules until January 1.)


Yesterday, in Washington, DC, the Senate Banking Committee was expected to grill federal regulators on what went wrong. Did banks know how much risk they were taking? Did they know how much capital they needed to cushion them from sour loans? Did they prepare themselves adequately for the evaporation of “liquidity”, or their ability to easily sell their securities or loans? The answer to all three questions appears to be “no”.


The recent financial blow-ups came largely not from hedge funds, whose lightly regulated status has preoccupied Washington for years, but from banks watched over by national governments.
Citigroup in last year’s fourth quarter had its worst-ever quarterly loss and had to raise more than $20bn in capital from outside investors to revive its balance sheet, after bad investments in mortgage securities. Citigroup declined to comment.


“I think it was surprising… that where we had some of the biggest issues in capital markets were with the regulated financial institutions,” said Treasury Secretary Henry Paulson in an interview.


As regulators worldwide start looking for lessons in the tumult, the result is likely to mean, at least temporarily, more government scrutiny and regulatory oversight of banks. Charlie McCreevy, commissioner for internal markets at the European Commission, said reassessment needs to examine whether banks are the best managers of risk. “There should be no taboos,” he said.


The Basel rules have their roots in the 1980s, when bank regulations varied dramatically from country to country, making it tough for banks to compete across borders. The world’s central bankers huddled in Switzerland to hammer out basic standards, which were unveiled in 1988.


A second round of talks, Basel II, focused on expanding those rules in particular, on seeking ways to defend the financial system against the complex new investment products becoming increasingly common at banks. The rules went into effect in European countries last year.  Next month’s limited phase-in in the US is likely to be delayed.
In the banking business, there are few things more core than the capital held by an institution to cushion against losses. At its essence, it is what prevents a bank from failing.


Under pre-Basel II rules, setting the level of this financial cushion is a relatively straightforward process: banks must hold a specific amount of capital, which is calculated based on the types of assets they hold. For example, mortgage-related assets do not require much capital because they have long been considered extremely safe.


The new rules would change that, letting banks calculate their need for capital reserves based in part on their own assessments of risk and the opinion of credit-rating agencies. Basel II has plenty of support. Federal Reserve officials have argued that its standards give banks incentives to bolster their risk management. In addition, Basel II requires institutions to maintain a safety net of capital to protect against trouble in “off balance sheet” holdings they may have, an issue that had largely escaped prior regulatory oversight. US Comptroller of the Currency John Dugan says the credit-market turmoil will strengthen Basel II by giving banks valuable new data to factor into their models.


Each country implementing Basel II has wiggle room to tinker. In the US, regulators wanted to tighten the rules. For them, the 1980s savings-and-loan crisis – when more than 1,000 banks failed amid unforeseen risks related to interest rates and real estate – remained a fresh memory.


Big banks, including Citigroup, lobbied aggressively in Washington for looser, European-style rules. They argued that tighter rules would make it tougher for them to compete globally, since more of their money would be tied up in the capital cushion. In June 2006 two Citigroup lobbyists joined Jim Garnett, the bank’s head of risk architecture, in a meeting in Washington with seven officials from the White House’s Office of Management and Budget, according to an official record. At the time, Citigroup held $80bn in core capital on its balance sheet to protect against its $1.1 trillion in assets, according to the Federal Deposit Insurance Corp.


In early 2007 Citigroup teamed up with other banking giants, including JP Morgan Chase, Wachovia and Washington Mutual, to meet the White House’s National Economic Council and argue their case again. In a February 2007 letter to regulators, the banks wrote: “To help ensure US banking institutions remain strong and competitive, the federal banking agencies should avoid imposing domestic capital regulation that provides an advantage to non-US banks.”


In July, the Federal Reserve and regulators handed a victory to the banks, letting them follow rules similar to those in Europe. That ruling potentially could enable American banks to hold leaner, European-style capital cushions.


By then, cracks in the global financial system were already spreading rapidly. Regulators both in the US and overseas say they are looking now to make changes to Basel II - which will likely require holding a higher level of capital against assets that were previously thought to be safe.


The Basel rules are being questioned as much for what they did not do as for what they did. Despite requests from some regulators, they contained few provisions for monitoring a bank’s liquidity – in other words, its ability to readily sell assets, or borrow affordably, to cover obligations. Last month, the Basel Committee said it plans to update its “core principals” for liquidity risk to “reflect recent experience”. One key principle behind the Basel rules is that banks are the best judge of the risks they are taking. In many cases, banks have slipped up. (The Wall Street Journal)