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A new reason why making banks hold more capital may not make them that much safer

Measures intended to make banks safer are actually putting them, in some ways, at greater risk. That’s the cautious conclusion of a report yesterday (pdf) from the Bank for International Settlements (BIS).

The international Basel III accord forces banks to hold onto more high-quality capital at all times. This capital comes in the form of “safe assets”—highly rated government debt and government-guaranteed mortgage-backed securities. According to the BIS, banks will need $4 trillion more of these assets to meet Basel III’s new capital requirements. The theory is that this capital should be able to absorb big losses if banks run into trouble.

Now, some analysts have worried that there simply aren’t enough such safe assets to go around. The BIS actually doesn’t think that’s a risk. It estimates that there are about $10 trillion more AAA and AA-rated government bonds than there were in 2007, plenty more than the extra the banks need.

However, there is more demand for these assets, both because of the capital requirements and because central banks have been buying up massive amounts of these bonds in an attempt to stimulate their countries’ economies (quantitative easing). The high demand means that US, Japanese, UK, and German bonds yield practically nothing.

So banks and pension funds are turning to private-sector alternatives, such as “collateral transformation.” In this process, banks magically turn clients’ ineligible assets (think junk bonds) into high-quality securities by lending them out to another institution—a pension fund, say, or another bank. That institution applies a discount (or “haircut”) to the bonds’ face value, and gives the lender the discounted amount in high-quality bonds or cash.

And therein lies the risk. The assets don’t change hands permanently: It’s just one institution lending junk bonds to another and borrowing higher-quality ones in return. So a default on one side could translate into problems for the other. In such cases, the “high-quality capital” is only as reliable as the low-quality capital it was exchanged for. Moreover, if assets on either end of such a deal are mispriced, it could have knock-on effects across the financial system.

As a result, warns the BIS, the financial system is becoming more interconnected—and thus more susceptible to system-wide problems of the kind we saw in the financial crisis a few years ago. William Dudley, president of the Federal Reserve Bank of New York, writes in a preface to the BIS study:

While this will mitigate collateral scarcity, these activities are likely to come at the cost of increased interconnectedness, procyclicality and financial system opacity as well as higher operational, funding and rollover risks.

This, needless to say, is not what regulators had in mind when they drafted Basel III. And it reinforces a belief of mine that capital requirements are part of a regulatory illusion—the idea that capital is a financial messiah that can mop up the bad bets of failing financial institutions and staunch systemic risk. But that’s an argument for another time.

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