Credit Market Fall-Out # 25 – Changes in the Reserve Requirements for Banks

The excerpts below from a WSJ article on the changing reserve requirements of banks and how this played into the current problems in the credit markets is interesting. Markets are “funny” places if you push in one place, it gives in another that no one anticipated. See the post below to see how this “give” fits into the capital markets.

Even before the current financial firestorm passes, the search for people and institutions to blame has begun: Greed and hubris overtook common sense and propriety. Excessively easy credit overwhelmed good judgment and fueled a housing bubble. Profit-grubbing crooks took advantage of unsophisticated home buyers. Rating services blew it. Government overseers couldn't keep up with financial innovation. U.S. regulators let shady subprime lenders slip through cracks in archaic rules. European bank regulators were blind.

The right answer will prove to be some combination of the above. One culprit, however, has gone unnoticed: A sweeping change in international rules governing the capital banks must hold. By requiring banks to boost the capital held in reserve against the loans carried on their books, the rules encouraged banks to get rid of those loans by turning them into securities to be sold to investors. Banks took the hint.

That's complicating the Federal Reserve's efforts to put out the current fire.

For more than 20 years, a club of central bankers has been tinkering with rules -- known as Basel, for the Swiss city in which officials meet -- to get banks to hold more capital so they can absorb major losses without threatening the financial system. Details are so technical that only insiders pay attention. Most of the time that's just fine. The battles over the rules typically have had more to do with banks and countries jockeying for advantage than anything that mattered to borrowers in Boise or Bremen.

The rules are rooted in the worries of wise men like Paul Volcker, the former Fed chairman, that banks didn't have enough capital, an especially acute concern after Germany's Herstatt Bank defaulted on obligations to foreign banks in 1974 and the U.S. government rescue of big Continental Illinois National Bank & Trust in 1984.

The solution: A 1988 international accord required banks (in countries where national authorities adopted the rules) to hold more capital if they make riskier loans and investments. A bank that loans $100 million to other solid banks needs only $1.6 million in capital; a bank that loans $100 million to ordinary companies needs $8 million capital.

Banks are a special case. They're traditionally at the center of the financial system; bank panics led Congress to create the Fed in 1913. And government insurance of bank deposits means most depositors needn't worry if their banks make foolish loans. That can give bankers a heads-we-win/tails-you-lose incentive to gamble that regulators must monitor.

The original Basel rules were crude, overwhelmed when banks figured out how to game them and were recently revised. The rules did succeed in getting banks to strengthen their financial footing. They did reduce the risks most banks take. Was that the intention? Yes. Is that always a good outcome? Well, maybe not.

Among other things, the rules required banks to hold more capital against an ordinary mortgage than against pools of mortgages turned into securities. So banks sold off individual mortgages and many replaced them with securities comprising pools of mortgages. Between 1988 and 1993, these mortgage-backed securities rose to more than 9% of bank assets from 2.9%.

This huge change in finance has advantages. Banks still make loans and hold them, but are more likely to originate and distribute loans. As a result, much of the risk of delinquencies on mortgages in inner-city Detroit isn't shouldered by local banks but has been shifted to investors all over the world. (How many of these hot potatoes may actually return to bank balance sheets is a question for another column. Short answer: More than some bankers would like.)

It turns out, the folks who hold mortgage-backed securities are forced to be much quicker than banks are to acknowledge reality when the value of the collateral for loans drops. And banks now behave more like securities firms, more likely to mark down the value of assets when market prices fall -- even to distressed levels -- rather than sitting on bad loans for a decade and pretending they'll be paid back.

It's a huge contrast to the bad old days of the early 1980s when big New York banks found themselves holding lots of bad loans to Latin American governments and took years to write them down -- or when Japanese banks' reluctance to admit the size of their bad-loans problem paralyzed Japan's economy.

But it may have some unwelcome effects: Banks aren't the shock absorbers they once were at a moment of market panic. Because they hold fewer loans on their books, banks don't have the ability to say, "These mortgages are more likely to be paid off than the market thinks today, and we'll just hold on until the market comes to its senses." Instead, the holders of mortgage-backed securities are dumping them, pushing down the price. This forces other leveraged players -- those backed by borrowed money -- to sell their holdings and, if not interrupted, an economically devastating downward spiral can take hold.

The Fed is now laboring to prevent such an outcome. But its tools are designed with banks in mind, not for a world in which banks have shifted risks to all sorts of other leveraged investors who are now forced to be obsessed with the value of their collateral.

The Fed, which was an enthusiastic proponent of these risk-based capital standards and securitization, is trying to prime the banking pump to put out the fire. Ironically, it's discovering that's harder because of unappreciated consequences of the Basel rules that were intended to make the banking system more fire-resistant.