29 January 2008

Telegraph: Northern Rock shows up mess of Basel rules

Now that some sort of resolution of the Northern Rock affair seems imminent, the question arises of how to prevent similar episodes in future. More specifically, do governments and regulators need to introduce more rules for banks? And - given the feedbacks between the American sub-prime crisis and the UK's system of housing finance - should such rules be international in scope?

The Basel rules - so-called because they are the responsibility of the Basel Committee on Banking Supervision - have their antecedents in the 1970s but really took off in the 1980s.

In that distant era numerous books were written about how the Japanese would dominate the world economy in the 21st century. International finance suffered a particular anxiety, that Japanese banks operated with unfairly low ratios of capital to assets.

This enabled them to undercut American and European banks in the pricing of loans, and helped them to capture an ever-increasing share of international banking business.

A few phone calls and meetings between officials at the US's Federal Reserve and the Bank of England led to an Anglo-American pact in October 1986 that there should be a level playing field in international bank competition.

More precisely, American and British banks should have similar capital ratios, and international co-operation should develop to enforce them.

The Americans and British managed to persuade the G10 group of industrial nations, including Japan, that their banks should also accept the principle of the level playing field and operate with a common set of capital rules. Since these rules came into force in the early 1990s, hundreds of books and thousands of speeches have been written about them.

In principle they define the gold standard of safe international banking in the early 21st century.

But there is a problem. In its last interim report - published in July 2007 relating to the first half of the year - Northern Rock boasted about its compliance with the latest Basel rules and even referred to the Financial Services Authority's recognition of this. Indeed, many of the banks that spent the last year writing off billions of dollars of bad debts were deemed by their auditors and regulators to have met the Basel rules at the end of 2006.

On the face of it, the Basel rules have failed. They did not prevent the American sub-prime crisis or the Northern Rock affair, and they did not stop a handful of medium-sized European banks taking hits so severe that they had to be quietly merged with better-run rival institutions.

Moreover, they have not given clear guidance to regulatory authorities and central banks on how to deal with the worst international financial imbroglio since the 1970s. What has gone wrong?

The first weakness of the Basel rules is that they concentrated on one type of risk, the risk that a bank would make too many bad loans and lose so much money on those loans that its capital was wiped out. But most banks face another kind of risk, that their depositors - perhaps without good reason - suspect that loans are going wrong and start taking out their cash.

The Basel rules related to the adequacy of capital relative to banks' loans (solvency); they said almost nothing about the adequacy of cash relative to deposits - liquidity.

Was there a rationale for this omission or was it merely a blunder?

The thinking may have been that - in the sophisticated modern world, with financiers in different countries better informed and more integrated than ever before - banks did not need to worry about cash. If one bank ran short, it could always borrow from another bank and, in the extreme, the commercial banks could go to the central banks and borrow from them.

The summer of 2007 refuted this comforting analysis. Despite almost universal compliance with the Basel rules, it became obvious that major banks - banks that were often household names not only in their own countries, but across the world - had no trust in each other's accounts.

A bank's report for end-December 2006 said that its holdings of securities were worth $50bn (£25.2bn); in May 2007 it acknowledged that they might be worth $49bn; in July neither its management nor anyone else knew precisely what they could be sold for, but it probably was not much above $42bn; in December 2007 the bank's management decided that the honest and correct figure was $38bn. And who knows if the saga of adjustments, and adjustments to the adjusted figure, is over?

Given the uncertainties in the valuation of assets, the scientific precision of the Basel rules was shown to be hocus-pocus.

Banks did not know the true state of each other's capital and, hence, their ability to repay loans. Inter-bank markets seized up. If one bank - such as Northern Rock - ran out of cash, it had only one place to go, its central bank. But the assumption that the central bank would, quickly and reliably, extend a lender-of-last-resort loan to a solvent, but illiquid bank - an assumption written into banking textbooks for decades - was invalidated by the Bank of England's reluctance to lend in crisis circumstances last August.

Banks in China and India have refused to sign up for the Basel rules and US banks have said they do not want to be involved in the latest efforts to refine them.

Will the Basel attempts to forge a worldwide set of banking rules, to create a level playing field for international banking, have to be abandoned - like a financial Tower of Babel - because of the inevitable conflicts and misunderstandings between jurisdictions, and the huge difficulties in interpreting the meaning of numbers in balance sheets?

The question does at least need to be asked.

By Tim Congdon

© The Daily Telegraph