Replacing Basel III and bringing more transparency for depositors

On April 9 in Basel, Switzerland, vice chairman of the American Federal Deposit Insurance Corporation (FDIC, similar to Europe’s deposit guarantee fund) Thomas Hoenig addressed members of International Association of deposit insurers with a speech entitled “Basel III Capital: A Well-Intended Illusion”. The piece is of the utmost interest in these times. Replacing Basel

For Mr Hoenig, all of the Basel capital accords, including the proposed Basel III, look backward and then attempt to assign risk weights into the future. “It doesn’t work,” he said. Basel III for him is a logical fallacy (an argument that seems valid but, in fact, is not), although he prefers to call it a “well-intentioned illusion”. The crisis has made clear that effective equity to deal with the losses were on average of around 3% of total assets; a ridiculous number to mend the harmful results of a developed speculative policy and whose outcome has put the countries complying with the Basil ratio at risk.

FDIC’s vice chairman heterodox proposal consists of replacing the Basel ratio and replace it with a “tangible leverage ratio” which only takes into account the owned resources (by deducting all intangible assets and fiscal deferred assets) and does not consider the risk of total assets arbitrarily (off-balance sheet derivatives should be included). With this new ratio all stakeholders will have synthetic information easier to understand and more independent of the risk variations in the future. The new leverage ratio tangible that Mr Hoenig estimates suitable for American banking is between 13% and 15% of total assets, like the one before the Federal Reserve and the FDIC were born. Mr Hoening suggests a schedule for adaptation.

Current banking orthodoxy, applied since 1990 and known as Basel ratio, consists in “someone” who sets weightings of risk that must be applied to each bank based on calculations of probability on its risk of default. It is discrete enough so that the possible inclusion of artificial incentives for some kind of “particularly suitable” investment is not noticeable. And that “someone” sets as well what is the “consumption of own resources” for each investment according to the risk. Bankers (the real ones, not the sales representatives that now use that name) are free to choose where to place their assets: their job is to get the maximum profitability of own resources (ROE) complying with the terms of the regulatory authority.

To sum up, Mr Hoenig says, the Basel ratio encourages bank speculation by favoring some sectors with a reduced weighting (sovereign debt, mortgages, derivatives…) and discourages financing in other sectors of criminalized weighting (commercial loans, industrial…) despite their greater propensity to saving.

When things are not as that “someone” forecasts, there comes the crisis and the adjustments. Depositors who thought their saving were safe, now realize they are trapped investors who will eventually face losses. May be changing the pattern from Basel ratio to a more realistic one (tangible leverage ratio), although needed, is not enough.

Perhaps we would have to start by changing the misleading name of deposit to what it actually is: a loan from depositors to the bank. And thus the responsible investor can compare and choose to which banks he wants to make a loan. Instead of simplifying balance sheets he should know the interest rate as well as all the relevant information (that is, to whom he is lending money and under what conditions, what is the portfolio diversification or concentration of risks associated with such action, which is the bank policy of debtors, operational net returns and other significant data).