Monday, June 27, 2011

Basel III

At last something decent from The Conversation. Today Imad Moosa provides an explanation of why Basel III will not protect us from a future financial crisis.

In simple summary, Moosa reminds us of the "procyclicality" of the banking and finance system. Something is procyclical when it correlates with the underlying driver. In finance the issue is usually noted that in recessions banks have to tighten lending (due to declining value of assets) which fuels the recession.

But the same is true in booms - and was a particular feature of asset valuation policy called "mark to market". If asset prices are increasing, then the bank can increase lending without any fundamentals changing. This is particularly true when they hold a derivative asset rather than the asset being an actual loan.

The issue of procyclical effects is ultimately at the source of all bubbles. People value assets in two ways. The first is on the value they can get returned from it - the income stream. The second is the future resale value. If the asset is investment real estate the income value is the net value of rental income, the future resale value is what you expect to sell it for.

Australian real estate is currently valued at about twice as much as the value of rental income. This is because expectation of capital gain has dominated the pricing model.

To make banking regulation less procyclical in the boom phase banking regulation needs to find a way to further load the risk weighting of assets if asset prices are increasing. Hence the standard Basel 1 model applied a 100% weight to owner occupied housing - the full value of the asset was assumed to be as good as cash. That value needs to be weighted to decline if house prices are accelerating faster than wages growth (or CPI) as that is the best proxy for affordable rental streams.

The second important point is that assets to be valued need open informed markets to ascribe those values. This is a market-design question (under my simple thesis the function of Government is market design). A failure of the derivatives "market" was the absence of an open "regulated" exchange.

There is a lot that can and should be done to improve the stability of the financial system, and it requires active Government involvement. Does anyone seriously believe that the banking and finance system developed to the point it has because the "free market" works. No it evolved as well as it has by good market design - including the role of Government in establishing fiat money.

Novae Meridianae Demetae Dexter delenda est

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