November 29, 2021

Today’s Economist: Simon Johnson: Betrayed by Basel


Simon Johnson is the Ronald A. Kurtz Professor of Entrepreneurship at the M.I.T. Sloan School of Management and co-author of “White House Burning: The Founding Fathers, Our National Debt, and Why It Matters to You.”

The fundamental assumption of modern bank regulation is that nations need to coordinate, and they negotiate the relevant international standards in the Swiss city of Basel, home to the Bank for International Settlements, under whose auspices such negotiations are held. The United States has an important seat at the table, but so do the Europeans and others. These negotiations are shaped by three main forces: the United States, Britain and the euro zone, with Japan often siding with the euro zone. (It’s one country, one vote, so this can easily go against the United States.)

Today’s Economist

Perspectives from expert contributors.

This week the Basel Committee on Banking Supervision, as it is known, let us down – once again. Faced with renewed pressure from the international banking lobby, these officials caved in, as they did so many times in the period leading to the crisis of 2007-8. As a result, our financial system took a major step toward becoming more dangerous. (A visual representation of the Basel Committee’s centrality to all key regulatory matters is clear on this organizational chart, as well as in its charter.)

Why did this happen? Must Basel always let us down? And is there any alternative?

You will no doubt have noticed that very large banks with a global span have an unusual degree of political influence. In particular, they have the ability to threaten the economic recovery. Their line is: if you don’t give us what we want, credit will not flow and jobs will not come back.

Policy makers in Washington are often impressed by this line, although less frequently than they used to be. More and more, managers have begun to understand that the people who run large banks have distorted incentives. Because they receive downside protection from the public sector – the too-big-to-fail phenomenon – bank executives want to take a great deal of risk. When things go well, they get the upside; when things go badly, that is largely someone else’s problem.

How does that desire for risk manifest itself? The banks lobby for the ability to fund themselves with more debt and less equity, and they also want to be less safe on other dimensions, including holding fewer liquid assets.

The Basel Committee this week agreed to water down its liquidity requirements. Felix Salmon of Reuters has a good explanation of why this is a bad idea. Writing in The Atlantic, Jesse Eisinger and Frank Partnoy have a very nice article about continued fragility of banking, because investors think the banks are hiding trouble in the published balance sheets. Confidence in the system is not restored by relaxing regulation.

The deeper problem with the Basel Committee is it overrepresents the euro-zone Europeans. Not only is the euro zone in great difficulty because of economic mismanagement, but its leaders are hoping to get out of their current predicament in part by relaxing bank regulation.

The idea that the Basel process is all about expertise – or smart people working out the right answers – is exploded by Sheila Bair’s book, “Bull by the Horns.” Read Chapter 3, in which she describes in convincing detail the fight over the Basel II agreement during the mid-2000s (and Chapter 4, which is more about how some United States agencies play against in each and on behalf their clients, the big banks).

What we saw before 2007 and what we see now is not officials applying some sort of optimization procedure or sensible independent thinking. Rather, this is about an industry that wants to take more risk because that is how it gets larger subsidies. And this industry is expert at playing the regulators off against each other, including across borders. The Europeans are again the patsy.

Unfortunately, some United States officials are so captured or captivated by the ideology of modern banking that they want to play along. For example, as Ms. Bair mentions, the most dangerous “advanced approaches” of Basel II were developed by the Federal Reserve Bank of New York – not surprising, given how close many people at that institution are to Wall Street. Those advanced approaches let the banks set their own risk-weights on assets, essentially using complex math to determine what was risky and what was relatively safe. Of course, they were almost completely wrong, and Basel II was a dismal failure.

Thank goodness Ms. Bair and her colleagues at the Federal Deposit Insurance Corporation resisted the full implementation of Basel II. Their insistence on simpler safeguards, including a tough cap on debt relative to bank size, helped make our financial crisis less severe than it would otherwise have been. The Europeans drank the Basel II Kool-Aid, and their banks loaded up on poorly understood risks. They will lose a decade of growth partly for this reason.

Now we have moved on to what is known as Basel III, and again the Europeans want to double down by letting the banks do want they want. The stock price of European banks jumped on the news of the latest Basel Committee relaxation of the rules – you should interpret that as a larger expected transfer from taxpayers to bank insiders and (perhaps) stockholders.

The United States must go it alone. Basel agreements should be a floor on our bank regulation (including bank capital, leverage and liquidity), not a ceiling. If our tighter rules induce dangerous banking activities to leave the United States, that is fine. In fact, we should offer to help them pack.

We need a financial sector that works for the real economy – not a continuation of the dangerous, nontransparent government subsidy schemes that have brought the Europeans to their knees.

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Sheila Bair’s Bank Shot

It was midmorning on a crisp June day, and Bair, the 57-year-old outgoing chairwoman of the Federal Deposit Insurance Corporation — the federal agency that insures bank deposits and winds down failing banks — was sitting on a couch, sipping a Starbucks latte. We were in the first hour of several lengthy on-the-record interviews. She seemed ever-so-slightly nervous.

Long viewed as a bureaucratic backwater, the F.D.I.C. has had a tumultuous five years while being transformed under Bair’s stewardship. Not long after she took charge in June 2006, Bair began sounding the alarm about the dangers posed by the explosive growth of subprime mortgages, which she feared would not only ravage neighborhoods when homeowners began to default — as they inevitably did — but also wreak havoc on the banking system. The F.D.I.C. was the only bank regulator in Washington to do so. During the financial crisis of 2008, Bair insisted that she and her agency have a seat at the table, where she worked — and fought — with Henry Paulson, then the treasury secretary, and Timothy Geithner, the president of the New York Federal Reserve, as they tried to cobble together solutions that would keep the financial system from going over a cliff. She and the F.D.I.C. managed a number of huge failing institutions during the crisis, including IndyMac, Wachovia and Washington Mutual. She was a key player in shaping the Dodd-Frank reform law, especially the part that seeks to forestall future bailouts. Since the law passed, she has made an immense effort to convince Wall Street and the country that the nation’s giant banks — the same ones that required bailouts in 2008 and became known as “too big to fail” institutions — will never again be bailed out, thanks in part to new powers at the F.D.I.C. Just a few months ago, she went so far as to send a letter to Standard Poor’s, the credit-ratings agency, suggesting that its ratings of the big banks were too high because they reflected an expectation of government support. If a too-big-to-fail bank got into trouble, she wrote, the F.D.I.C. would wind it down, not bail it out.

As an observer of the financial crisis and its aftermath, I have frankly admired most of what she tried to do. She was tough-minded and straightforward. On financial matters, she seemed to have better political instincts than Obama’s Treasury Department, which of course is now headed by Geithner. She favored “market discipline” — meaning shareholders and debt holders would take losses ahead of depositors and taxpayers — over bailouts, which she abhorred. She didn’t spend a lot of time fretting over bank profitability; if banks had to become less profitable, postcrisis, in order to reduce the threat they posed to the system, so be it. (“Our job is to protect bank customers, not banks,” she told me.) And she was a fierce, and often lonely, proponent of widespread mortgage modification, for reasons both compassionate (to help struggling homeowners stay in their homes) and economic (fewer foreclosures would help the troubled housing market recover more quickly).

I thought something else as well: with her five-year term as F.D.I.C. chairwoman drawing to a close — her last day was July 8 — she never really got her due. The rap on her was always that she was “difficult” and “not a team player.” There were times, in Congressional testimony, when she disagreed with her fellow regulators even though they were sitting right next to her. Her policy disputes with other regulators were legion; in leaked accounts, Bair was invariably portrayed as the problem. In “Too Big to Fail,” for instance, the behind-the-scenes account of the financial crisis by the New York Times business columnist Andrew Ross Sorkin, Bair is described as one of Geithner’s “least favorite people in government.” As Paulson, Geithner and the Federal Reserve chairman, Ben Bernanke, raced to bail out banks and companies like A.I.G., Bair resisted, fearing that they were being overly generous by putting the interests of bondholders over those of taxpayers. I couldn’t help recalling that the last female financial regulator to be labeled difficult was Brooksley Born, the head of the Commodity Futures Trading Commission in the mid-1990s. Fearful that derivatives were becoming a threat to the financial system, Born wanted to regulate them but was stiff-armed by Alan Greenspan and Robert Rubin.

Joe Nocera is an Op-Ed columnist for The Times and the co-author of “All the Devils Are Here: The Hidden History of the Financial Crisis.”

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