ECONOMICS:Basel II failed because it led to a relaxation of capital minimums when the opposite would have been more appropriate, writes PAT McARDLE

BASEL IS A sleepy Swiss town where nothing much happens – the kind of place that responds to occasional vandalism by mounting spotlights and making an exhibition of a broken shop window instead of repairing it. Located on the Rhine near where the Swiss, French and German borders meet, historically it has been a venue for peace negotiations and international meetings.

Nowadays Basel is best known as the home of the Bank for International Settlements (BIS), the central bank of central banks, where bank regulators meet to try to agree global rules for banking. It is not an easy place to get into and few non-central bankers cross its threshold. I last visited many years ago when I participated in a rare joint central bank/treasury working group.

As you might expect, the BIS is flush with cash and its facilities are second to none, although its past is a bit shady.

When I visited, the BIS was one of the few, possibly the only, buildings in Europe to have window shutters that responded to the intensity of the sunlight.

Possibly of more note, the BIS was the only institution that I know of to warn explicitly of the danger of a credit crisis but it was roundly ignored.

As frequently happens, the Basel Committee on Banking Supervision (BCBS) was formed in response to a crisis – the collapse of the German bank Herstatt in 1974.

In 1988, the BCBS proposed a set of minimum capital requirements for banks, known as Basel I, which came into effect four years later – ie almost two decades after the committee was established. Things move slowly in Basel and international agreement is hard to come by.

Bank assets were split into five categories carrying risk weights which varied with the (perceived) credit standing of the borrower.

These ranged from zero for purchases of government bonds to 100 per cent for retail and corporate lending, with mortgages a kind of half-way house with a 50 per cent risk weighting.

Banks were required to hold capital equal to 8 per cent of risk-weighted assets – ie a bank that lent exclusively to private companies had to hold a minimum of 8 per cent capital. This was no more than a simple rule of thumb but it lasted for the best part of two decades.

Although Basel I was eventually applied in more than 100 countries, it was widely abused. The simplest way to avoid it was to set up a special purpose vehicle (SPV) with a separate legal identity and sell the loans (assets) to it, thereby circumventing the capital requirements almost completely. At least one well-known example of this type of SPV popped up in the IFSC early on in the crisis.

The extent to which the parents would or would not stand behind these SPVs was a major issue in the early stages of the bank crisis.

Credit default swaps (CDS) could also be used to lower capital requirements and some big US banks managed to get their actual capital holdings down to 2 per cent or even less. Irish banks securitised €34 billion mortgages, thereby moving them off balance sheet and freeing up the funds for fresh lending.

Roll on Basel II.

The EU capital requirements directive implemented the Basel II capital adequacy framework and applied it to all investment firms, building societies and banks from January 1st, 2007. However, it never really came into effect as it was overtaken by events.

Basel II was very complex, with three pillars and three versions, allowing multiple permutations. All that did was provide work for a host of advisers and risk people, few of whom really understood it. It had nearly 1,000 pages of legislation and was described by the US comptroller of currency as “complex beyond reason”. The Honohan report last week said it distracted the Financial Regulator and so was a factor in the banking crisis.

The simple version of Basel II actually lowered capital requirements because it reduced the risk weightings on mortgages and consumer loans.

The standardised version also introduced reliance on credit rating agencies to determine risk, an effective outsourcing of part of the regulatory function which has now been called into question given the disastrous role played by the rating agencies in the current crisis.

Meanwhile, the advanced Basel II version came close to letting banks set their own risk capital using complex internal models and stress testing with supervisory oversight. It is now widely accepted that inadequate stress testing was another contributory factor to the crisis.

Basel II also provided for an operational risk charge in order to cover “the risk of loss resulting from inadequate or failed internal processes, people and systems, or from external events”, but this didn’t save the day either.

The intention was that Basel II would not change the amount of capital held by the banking system but would redistribute it towards banks that engaged in higher-risk activities. For example, Irish Life Permanent was expected to benefit because it had a large mortgage book which attracted a lower risk weighting.

The work on Basel II was led by E Gerald Corrigan, chief executive officer of the New York Fed, a genial man of Irish ancestry, who was invariably willing to stop over in Dublin to give an update on progress (or lack of it) on his frequent transatlantic visits to Basel.

Basel II was conceived in an era of deregulation. It took six years to complete, lowered capital requirements by as much as 29 per cent and failed to prevent the collapse of the banks that adopted it. It failed because it led to a relaxation of capital minimums when the opposite would have been more appropriate.

It will be superseded by a very different animal, already known informally as Basel III and spurred by G20 leaders, who urged the Basel Committee on Banking Supervision to improve the quantity and quality of capital, strengthen liquidity requirements and discourage excessive leverage.

This time the process is being driven by the politicians. Bankers, be they in central banks or otherwise, will have less influence.

Next week: Will the politicians succeed where the regulators failed?