B.A.S.E.L

By Things that make you go Hmmm. The number three is considered lucky in China because its pronunciation is similar to that of the word for ‘alive’ (sadly, the number four is similar to the word for ‘death’ so Rony Seikaly wouldn’t have sold many replica shirts in Beijing even if the NBA HAD been popular in China prior to Yao Ming’s arrival), while in Vietnam, a photograph containing three people is said to be unlucky as the person standing in the middle will soon die.

During WWI, no soldier would take ‘third light’ – which was to be the third person to light a cigarette from the same match or lighter – as an enemy sniper would see the first light, take aim on the second and fire on the third and we are all familiar, no doubt, with the Three Blind Mice, The Three Bears and The Three Little Pigs.

Bad luck, it is said, always comes in threes.

Over the next several years, we will see the gradual phasing-in of the higher minimum capital requirements laid out in the third of the Basel Accords which were agreed upon by the Basel Committee on Banking Supervision – or, to give it its most familiar name – Basel III.

As one can deduce from its title, Basel III is the third set of capital requirements that the Basel Committee have produced dating back to 1988 – when the original Basel publication provided a solution to a problem that had occurred some 14 years prior when, in 1974, the Cologne-based Herstatt Bank was at the centre of a rather messy liquidation.

On June 26 of that fateful year, a group of banks had released Deutsche Marks to the Herstett Bank in exchange for dollar payments deliverable in New York but, in a world where instantaneous transfers of billions of dollars was impossible, the time difference between Cologne and New York caused a delay in the payment of the dollars to the counterparty banks in the USA and, before those payments could be effected in New York, German regulators – ever the last bastion of efficiency – stepped in and liquidated Herstatt Bank.

From the ashes of the Herstatt debacle arose a powerful phoenix:

(Wikipedia): That day, a number of banks had released payment of Deutsche Marks (DEM) to Herstatt in Frankfurt in exchange for US Dollars (USD) that was to be delivered in New York. Because of time-zone differences, Herstatt ceased operations between the times of the respective payments. The counterparty banks did not receive their USD payments.

Responding to the cross-jurisdictional implications of the Herstatt debacle, the G-10 countries (the G-10 is actually eleven countries: Belgium , Canada , France , Germany , Italy , Japan , the Netherlands , Sweden , Switzerland , the United Kingdom and the United States ) and Luxembourg formed a standing committee under the auspices of the Bank for International Settlements (BIS). Called the Basel Committee on Banking Supervision, the committee comprises representatives from central banks and regulatory authorities. This type of settlement risk, in which one party in a foreign exchange trade pays out the currency it sold but does not receive the currency it bought, is sometimes called Herstatt risk.

In 1988, the Basel Committee published a set of minimal capital requirements for banks which became known as the 1988 Basel Accord. It was enforced by law in the G-10 countries in 1992 and focused primarily on credit risk. Bank assets were grouped into five different levels, each of which carried a haircut according to the perceived risk in holding them. The risk weights were 0%, 10%, 20%, 50% and up to 100%. The Accord required banks to hold capital equal to 8% of their risk-weighted assets. Highly-rated sovereign debt was given a risk-weighting of 0% as it was, unquestionably, the form of credit risk least likely to default – in fact, given it received a 0% risk-weighting, it was, implicitly, guaranteed NOT to default. How quaint.

The creation of the first Credit Default Swaps (widely credited to JP Morgan in the wake of the Exxon Valdez disaster in 1994 when a team of J.P. Morgan bankers led by none other than Blythe Masters sold $4.8bln of credit risk to the EBRD to lessen the reserves they needed to hold against a possible Exxon default) enabled banks to further reduce the amount of risk capital they had to hold to comply with The Basel Accord.

The principles established by the Basel Accord were adopted by over 100 countries although, as Wikipedia so deliciously points out:

The efficiency with which they are enforced varies, even within nations of the Group of Ten.

In 2004, the Committee published their second set of recommendations which once again, had lofty intentions:

(Wikipedia): The purpose of Basel II…is to create an international standard that banking regulators can use when creating regulations about how much capital banks need to put aside to guard against the types of financial and operational risks banks face while maintaining sufficient consistency so that this does not become a source of competitive inequality amongst internationally active banks. Advocates of Basel II believe that such an international standard can help protect the international financial system from the types of problems that might arise should a major bank or a series of banks collapse. In theory, Basel II attempted to accomplish this by setting up risk and capital management requirements designed to ensure that a bank holds capital reserves appropriate to the risk the bank exposes itself to through its lending and investment practices. Generally speaking, these rules mean that the greater risk to which the bank is exposed, the greater the amount of capital the bank needs to hold to safeguard its solvency and overall economic stability.

Seemed like a good idea at the time – but then so, presumably, did New Coke and the 8-track cassette. However, despite the chances of Basel II being successfully policed being as straightforward as a post-EU summit press conference, and with banks being the capricious creatures that they are, the principles set out within the Accord became obstacles over, below or around which routes needed to be found and that meant lobbyists; lots and lots of lobbyists (I believe the collective noun for such creatures is a brothel, but I stand to be corrected).

In September 2005, entirely of their own volition, the US OCC, the Federal Reserve Board, the FDIC and the OTS announced revised plans for the implementation of Basel II that would delay its implementation for US banks by 12 months.

Further revisions followed in November 2005 and July 2006 until, in November 2007 the US OCC approved a final rule implementing the Basel II Capital Accord. The rule laid out regulatory and supervisory expectations for credit and operational risk. It arrived in the nick of time for the collapse of the 38:1 levered Bear Stearns in March of 2008.

In the wake of Bear Stearns’ ignominious demise, a further update was issued in July 2008:

(Wikipedi): On July 16, 2008 the federal banking and thrift agencies (the Board of Governors of the Federal Reserve System, the Federal Deposit Insurance Corporation, the Office of the Comptroller of the Currency, and the Office of Thrift Supervision) issued a final guidance outlining the supervisory review process for the banking institutions that are implementing the new advanced capital adequacy framework (known as Basel II). The final guidance, relating to the supervisory review, is aimed at helping banking institutions meet certain qualification requirements in the advanced approaches rule, which took effect on April 1, 2008.

Fortunately, this updated guidance was published BEFORE Lehman Brothers’ 30:1 leverage caused its collapse in September of the same year.

Now we stand on the cusp of the implementation of the latest and greatest Basel Accord – Basel III. One can only hope that this part of the trilogy isn’t to banking what the Godfather III was to the movie industry.

Full must read Hmmm November 20