Sunday 25 December 2011


UPDATE: A Greek version of this post was published on 5 Jan 2012 by

In my months of relative absence I’ve been reading this blog over and over again, looking for things I ought to have done better or things I used to do well but no longer do. I realised my favourite post by a wide margin was this one, because it told a story that not all commentators are well-placed to tell, and without which any discussion of the Greek debt crisis is doomed to miss the point completely. Today, as a special Xmas treat to my loyal readers, I have got a new historical post, and it’s a good one I promise.

Our story is set in Switzerland, where Greek millionaires  (and, one account tells me, Cretan goatherds) keep their money. However, our villains are not the Gnomes of Zurich, but the Grinches of Basel.

Readers will know that I’ve got a special interest in capital regulation in my professional capacity, and I’ve also had the good fortune of being allowed to write a little bit on the impact the new capital regulations (Basel III, implemented in Europe within CRD IV) are likely to have on loans to small and medium sized enterprises. You can find the global discussion paper here and the European policy paper here. However, mine is only a passing amateur interest compared to that of Patrick Slovik at the OECD, who recently sent me his latest work on what capital regulation has actually done to the banking sector globally. It is this paper that inspired our Christmas carol.

If you’re new to the concept of capital regulation, then the story goes a little like this. 

Banks are required by law to hold on to a certain amount of money against what they lend so that, if they should make losses or if depositors should rush to get their money back, they will still have enough money to meet their obligations and keep functioning. Banks would, in their own best interests, hold on to some money anyway, but in many cases they don’t appreciate how their lending decisions or other transactions affect the total system and how the troubles of other banks could affect them; so they are likely to hold on to less money than they should. Hence, the reasoning goes, regulators have to make it mandatory for banks to hold on to a certain level of capital that is higher than what banks would set aside on their own.

In 1988, a concentrated effort was made by central bankers around the world to agree on principles of capital regulation that would apply globally. The trigger was the failure of a German bank back in 1974, which today would have been a mere blip on the radar of EPIC FAILZ but was a big deal at the time. Because the Committee that was formed to prepare these standards met for the most part in Basel, this first set of standards was known as the Basel Accord and its two latter incarnations are known as Basel II and Basel III. Collectively they are known as the Basel Accords.

(Lords of Ka-Ching, by William Banzai

The clever idea behind the Basel Accords (and one that, in principle, it is hard to argue with) is that the amount of capital banks should set aside should depend on how risky their activities are. I could tell you that one myself. If you’re a specialist bank lending to start-ups (hint: there is no such thing) it makes sense to hold on to a lot of capital, because about a quarter of start-ups (in Europe) never make it past their 2nd birthday. If on the other hand, you are a niche player lending only to large fast-moving consumer goods companies like Unilever or P&G, then you shouldn’t need to worry as much. Basel doesn't quite work like that but the principle of 'more risk, more capital' is the same. 

The problem is that there is no single way of assessing credit risk, and, in the case of loans, banks each use their own methods for doing this, the tiny variations of which are essentially industrial secrets. So the only way regulators could create any system of capital requirements that banks would not reject outright was to come up with their own assessment of how risky different types of activity actually were. Each asset (such as a loan, or a bond, or whatever) would receive its own risk ‘weight’ (determined by the regulators) and the banks would have to calculate a risk-weighted version of their balance sheet before deciding how much capital the regulator wanted them to hold. This in turn meant that assets the regulators had decided were ‘riskier’ would become more expensive for the banks to keep on their balance sheets because they would come with a higher capital requirement – and capital is expensive to raise because shareholders and other providers of capital have to be compensated for the risk they take.

Since Basel I was implemented in 1991, the assets of big banks have grown year after year, but the ratio of risk-weighted assets to total assets declined year on year (see below). Between 1991 and 2008, it fell by a full 50%. Now it’s hard to believe that the banks dropped half of the risky business they did from their balance sheets, because plainly the banks of 2008 were toxic and the banks of 1991 were, well, less toxic. So if the banks didn’t drop risky assets, what did they drop from their balance sheets? You guessed it, they dropped whatever the Basel regulations (I and then II; III is still on its way) had decided was ‘riskier’. Any guess what was ‘risky’ according to Basel? You guessed right. It was loans. Loans! You know, the stuff banks are supposed to make. By 2007, Deutsche Bank, for instance, only had 11% of its balance sheet in loans.

Which begs the question, what was the rest of the balance sheet made of? Why, the stuff Basel had decreed was ‘safe’. And what was the safest type of lending conceivable to Basel? You guessed it. Bonds. Yummy government debt. And, occasionally, short-term loans to major banks, preferably with government bonds thrown in as security. So were AAA-rated securities made out of bundles of iffy mortgages. Pretty much everything that's gone wrong in the world since 2006. But let's focus on bonds for now.

Basically, what happened was that banks took one look at their balance sheets and started dropping everything except ‘no-brainers’. So if the answer to the crucial question of ‘are we getting our money back?’ was ‘ooh, that depends, let me see’, the asset was dropped. If the answer was ‘yes unless Hell freezes over’, the asset was kept. OK, this is not exactly the way it happened but if you fast-forward the banks’ balance sheets in time, that’s kind of how it looks.

What do banks mean by ‘unless Hell freezes over?’ Well they mean cases in which their fundamental assumptions about the world turned out to be wrong. Basically, capital regulation gave banks an incentive to swap mundane risks for what is technically known as ‘tail risk’, or more popularly, as ‘Black Swans’.  I am not the only one saying this. In fact, the IMF woke up to this fact earlier this year when Perotti et al wrote their future classic on capital regulation. So what were these fundamental assumptions the banks could always count on? In the days leading up to 2007, the banks had come to count on property prices only ever going up (at least country-wide; so even though mortgages might be risky, mortgage securities weren’t. In the days leading up to 2009, they had come to count on Eurozone sovereigns not defaulting. The rest is history.

The banks’ crimes are many and heinous but probably the worst was the fact that, for the sake of a few cents to each dollar or Euro or whatever, they outsourced their risk management to the Basel regulations and anyone recognised as a competent authority by said regulations. By the way, in case people are wondering who gave the rating agencies the right to decide how risky European sovereigns are, or, more precisely, why banks and other institutions feel compelled to listen to the rating agencies, you’ll be interested to know that it was Basel wot did it. For instance, just check out the original text of the European implementation of Basel II (known as CRD III), as it was finally adopted in 2006 (of course it was years in the making so banks started adjusting to it as early as June 2004 when Basel II was agreed). You’re looking for the beginning of Article 81, on page 34 here. Yep. In your face.

Similarly, by allowing banks that hedge using CDS to reduce their capital requirements, Basel also made the CDS market so crucial that it refuses to die even after it's become clear that CDS will not protect Greek creditors.
Now although Basel I and II gave banks an incentive to dump loans and stock up on bonds, they didn’t tell them what bonds to stock up on. They just gave them a nice hint. Paragraph 64, p. 116 here tells the banks how to do it. Assentially, it says, go to your credit rating agency, look up governments’ credit ratings and derive the default probability from there. Or calculate it yourself, but why bother? In 2006, Greece’s credit rating was A1 according to Moody’s and A according to S&P and Fitch, which meant a 5-year default probability of less than 0.1%. Basically zero, and zero was the actual amount of capital a bank had to set aside when it lent money to Greece. Zero was also the amount of capital a bank had to set aside when it lent money to any other Eurozone country, except Greek debt had a slightly (veeery slightly) higher yield. The difference might have been small but when the banks are leveraged by 31x (as the major banks were in 2006) and they hold tens of billions of debt, even a small difference could make them lots of money.

Banks, in short, had a massive incentive, from 1992 onwards, to buy the debt of the Worst ‘Decent’ Country in the World. A country that would benefit from being in the Magic Circle of sovereigns no one believes will ever default, but is just at the edge of the Magic Circle so that it has to pay a little bit extra interest on its debt. That country was Greece, and our debt soon became irresistible. This pursuit of the ‘Worst Decent Country’ is the reason why, against all reason, European bond yields converged even before the Euro became a reality, starting from (you guessed it) 1992 onwards, until the spread between German and Greek bonds became almost zero. Basically, the banks arbitraged the spreads away because Basel always seemed to be telling them to buy the highest-yielding ‘safe-ish’ bond possible. This would increase the prices of such bonds, making the spreads tighter. If you don’t believe me, look at the chart below (originally from here)

The Euro, which many like to blame all of our woes on, only made us the Worst Very Decent Country in the world, but it did little to fundamentally change the dynamics. These were locked in by Basel.

So there you go, my friends. The moral of this Christmas tale is ‘Never outsource risk management to other people.’ Also I think we’ve contributed a new slogan to the ongoing efforts to rebrand Greece for tourists. I doubt ‘Worst Decent Country in the World’ will catch on but hey, it’s 3am, cut me some slack.

Good night everyone. Merry Christmas to you and your loved ones.

UPDATE: Since people are asking, I believe that capital regulation is horrible at dealing with tail risk and provides perverse incentives. For me the best way of dealing with tail risk is full personal liability for bank management, board members and controlling shareholders, including ca. 5 years after they've moved on. This means their properties are on the line as soon as banks go bust. I don't believe in limited liability anyway. A business is a machine for making shareholders money. It should not have rights or protections (or obligations) other than those reconcileable to the the rights, protections or obligations of its shareholders and physical persons.

If (and only if) this is in place, I believe that we should let banks decide how much capital they should hold on to, and let shareholders decide if they are happy with capitalisation. Both sides have outsourced this task for too long, and with disastrous effects.


  1. Very educational, thanks Mano!

  2. So the conclusion is that regulation is bad or that it was badly implemented?

  3. Friend you are very close to the truth, so let me give you a final push in that direction. The problem has not really a lot to do with whether the risk assessments or perceptions are correct or not… the problem with the Basel capital requirements for banks is the following:

    Banks and markets already clear for the perceived risks of default contained for instance in the credit ratings, by means of interest rates, amount lend or other terms. So that when the regulators used exactly the same public sources of risk perceptions to also set the capital requirements they doomed the banks to overdose on perceived risk and, as a consequence, we now have banks with dangerously obese exposures to the “not-risky”, like to triple-A rated paper and “infallible” sovereigns, and equally dangerously anorexic bank exposures to what is officially perceived as risky, like to small businesses or entrepreneurs.

    Who did the Eurozone in?

    1. @Per Thank you! I agree completely. I've written much the same in my professional capacity. Check out pp. 4-5 here:


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