The International Bank Rule That Almost Destroyed The World

Courtesy of John Carney at Clusterstock

Martin Jacomb gets to the heart of one of the least understood aspects of the bubble that broke the banks: why banks bought and held so much securitized debt.

Under one now-discredited theory, banks made so many toxic mortgage because they could securitize them and offload the risk to others. But this doesn’t explain very well why the banks wound up with so much of the toxic securities on their balance sheet. Banks owned almost half of all the securitized mortgages that were produced during the bubble.

Jacomb’s FT op-ed today explains why this happened: because the capital reserve requirements rewarded turning loans into securities and more or less paid banks to hold them. In short, the rules told banks that the securities were safer and banks behaved as though they were. (Whether the rule or something else convinced the banks they were safe is another matter.)

From Jacomb:

In fact, at the heart of the present catastrophe was a singular regulatory error: the failure of the Basle international rules to impose weighty capital requirements on the super senior tranche of securitised mortgage obligations held in banks’ trading books. It was there that vast quantities of the toxic stuff accumulated. Because these securities could be held with minimal capital backing, banks thought it was all right to do so, and some built up gigantic portfolios. When these holdings turned out to be unsaleable except at a huge loss, the disaster was exposed.

People tend to let their eyes glaze over when they hear about Basel rules, assuming they are way too complicated to even bother understanding. That’s too bad. Because it’s actually quite easy to see what happened.

Under the international Basel capital requirements, a well-capitalized bank was required to hold $4 for every $100 in individual mortgages —a 4% reserve requirement. But if it held the securitized the AAA and AA tranches, the bank only had to hold $1.60 in capital. That’s a huge incentive to trade in a loan for a mortgage backed security.

But the capital regulations did more than just create incentives to own mortgage backed securities. They allowed banks to dramatically grow their balance sheets. The lower reserve requirement allowed banks to buy even more securities than it could make loans. A bank with $4 billion in reserve could hold $100 billion in loans. But that same $4 billion could instead be used to invest in $250 billion worth of mortgage backed securities.

Another way of looking at this is that banks were basically making money—turning $100 into $250—by flipping mortgages into securities. And the government rules were, effectively, telling them that this was a perfectly safe thing to do.

Reference: Regulators and bankers must share the blame, by Martin Jacomb, FT.