Sunday, February 5, 2012

WSJ: EU May Back Away from Basel

Regulators Under Pressure from Lobbyists 
On February 2nd, the Wall Street Journal reported that European regulators are considering loosening rules on Capital Requirements. EU Policy makers and regulators are weighing whether to permit banks to hold a broader variety of assets to meet new safety standards. Because the current rules are the product of G20 negotiations and have been implemented across the OECD, relaxation of the rules is likely to spark a fight with policy makers across the world. 

As if we learned absolutely nothing from 2008, EU regulators are considering allowing “Asset-backed instruments [ABS] of high liquid and credit quality”. In other words, banks will be allowed to have "AAA-rated" Mortgage-Back Securities instead of actual safe assets in order to meet their capital requirements. 

This is ostensibly being done as a short cut to make it easier for banks meet core capital requirements. Because one aspect of the current recovery period is marked by the reluctance of banks across the OECD to engage in new lending of any kind, such a step might encourage banks to start lending again. If only things were so simple. While restarting lending is critical to economic recovery, we should not be so naive as to do this by feeding the underlying cause of the crisis. Certainly, the Vienna Agreement whereby bankers from across Europe were encouraged not to pull out of Eastern Europe, where the primary bank activity consists of private lending and project finance demonstrated the importance of the role of lending. 

In this spirit, it may be a good idea to try to think outside the box. While we need to restart lending in productive areas of the economy, we also need to ensure that bank capital is as solid as possible. In other words we need to leave the capital rules as they have been established, and engage in lending by alternate means. 

What Would Hayek Say?
To state is plainly, von Hayek believed that mal-investments wreck the economy. According to the Austrian school what we really need to be concerned about is care-less investments which do not yield what they should and do not add to productivity. This is how economics slumps are born, and they start out as bubbles. This sort of relaxation of financial rules would lead to exactly the type of mal-investment Hayek and the Austrians were talking about.

What Keynes Would Say
As Skidelky has noted, Keynes was a proponent of directly addressing the sources of economic troubles. generally, he was a proponent of using the influence of the state as an alternate means of distribution in both the fiscal and the monetary sense. 

German Historical School Would Say...
The doctrine of Historical School is established (as the name states) based on a study of economic history. To that effect:

1: ABSs under questionable AAA rating being used as Basel II capital was at the core of the 2008 financial collapse. Letting ABS be considered as capital yet again cannot lead to anything good.

2: More generally, we should examine post-crisis economic recovery periods which came after the collapse of the bubble. While it is true that employment and economic growth lag for as much as a decade after the collapse, stable economic recovery has only been possible under the auspices of smart regulation which addressed the underlying causes of economic stability. Its as true for the tulip bubble as it is in 2012. 

What We Need 
Simply stated, the capital rules and financial regulations established by the G20 and the Basel III rules need to stay in place if we are to have a stable recovery built on the recovery of real, tangible economic output. While the process may be slowed by bank lending reluctance due to the new capital requirements, we can use alternate means to distribute lending to the productive real economy. For example, project finance and real estate lending could be distributed by municipal authorities under central bank auspices. This would restart lending and reduce some of the need for radically expansive monetary growth in one bold stroke.

About the Author:
Max Berre is an economist at the EDHEC-Risk Institute who has worked as a sovereign debt expert at the Inter-American Development Bank in Washington and has taught financial economics at Maastricht University in the Netherlands


  1. Good article! Thank you for enlightening us.

  2. Totally agree! And shouldn't we think even more about the crucial point "what Keynes would say"? Because it seems obvious that he has a lot to say here: if private demand for money cannot be met by private supply, then there must be public money supply to close the gap - and not a lowering of standards to "encourage" private supply (the idea is outrageous, applied to other sectors of the economy as well)...