Sunday, July 22, 2007

U.S. signs on to implementing Basel II

This is one of those really really big deals that practically nobody knows about--a case strong enough to resurrect Mancur Olson just so he can point his finger at all those Public Choice haters out there and say, "See, this is exactly what I meant!"

"Basel II" is the second set of international agreements on banking regulation created by the Basel Committee on Banking Supervision, which is itself a group of central banks from a dozen or so of the world's most developed economies. Unlike securities regulation, which tends to focus on investor protection, and insurance regulation, which tends to focus on the safety and soundness of the institutions, banking regulation is all about systemic risk. (Of course, all financial regulators focus on investor protection, soundness of financial institutions, and systemic risk, but we're talking about emphasis here.) From a banking regulator's perspective, the worst case scenario is not that a bank fails or some customers get ripped off, but that the system itself is brought into question. When that happens, as it did in 1929, you get the proverbial run on the banks, and then the world goes to hell in a handbasket, regardless of how many investor protections you've built into your regulation or how strong the individual institutions are. And, as we all know, the only thing that's going to save your economy's sorry ass when that happens is Jimmy Stewart explaining basic finance to a bunch of town yokels.

The second accord of the Basel Committee on Banking Supervision (or Basel II, as it's known to its friends) is designed to help protect the international financial system against systemic shocks by setting global standards on capital reserves and other aspects of banking regulation. The lessons of banking crises over the past 30 years or so (and particularly the 1997 Asian Crisis) shows that a collapse of the financial system in one country can be contagious and produce risks to the financial systems in other countries as well--even if those other countries have better regulatory oversight. That's because, in today's world, everybody is invested in everybody else, so if everybody in one market defaults at the same time (as happens more often than you might think), it could effect a major international bank invested in that market. And if that major bank goes belly-up, people start wondering about the strength of all those other major banks--and pretty soon you have a run. So, to put a stop to this type of problem, the big country central banks got together to create a uniform world standard on how banks should measure risk and set cash aside for a rainy day. Being a world standard would make it harder for some countries to "cheat" and let their banks set aside less than everyone else.

The first Basel accord, agreed to in 1988, was very basic by today's standards and was soon overtaken by new risk-measurement tools. Hence, Basel II. The fun thing about Basel II is that it is absolutely incomprehensible to everyone other than a handful of banking regulators, who themselves are incomprehensible to all other humans. Nonetheless, like all banking regulation, it involves a whole lot of money. I mean, really really really large sums of money. So, a tweak here or there can mean some bank goes out of business or else the president of that bank gets a $1 billion check in his or her Christmas stocking. Making matters more fun has been the long-standing disagreement between two of the United States' myriad banking regulators--the Federal Reserve and the Federal Deposit Insurance Corporation. I don't really understand the details of this disagreement--and by "details," I mean "anything at all"--except that the large US banks wanted one thing and the small US banks wanted something else, with the result that the European banks were worried that in the end they were going to be really screwed over. Hmmm, so many delicious choices! But all of this led to a very interesting situation where you had Congressmen holding hearings on this issue and reading questions off index cards to the various banking regulators, with neither the questions nor answers being understood by either the Congressmen or their staffs. This, itself, is not that unusual, but what was really interesting was that the industry lobbyists pushing for various concessions often didn't understand what they were pushing for, either. It's just that arcane.

Which gets back to Public Choice theory. Public Choice says that most policy issues are just too complex and tiresome for most people to pay attention to, unless the issue has a very strong impact on them. Hence, we get subsidies for milk producers, even though the average taxpayer and consumer is made worse off by these subsidies--but only a little worse off, while a few milk farmers are made very much better indeed. With Basel II, however, we have a situation were the policy issues may be just too complex and tiresome for anybody. What happens then?

The Financial Times writes about it here.

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