Basel I: The Japanese Financial M&A Boom and Bust

Basel I was implemented in the late 1980s and allowed banks a great deal of freedom and latitude to incorporate cross-holdings of financial affiliates in their calculations of prudential capital. What could go wrong with this? If you own a subsidiary bank, why not allow the capital of this bank to be counted in your own capital? A bank holding company with many subsidiaries should be allowed to stand on its own two feet as a consolidated entity.

This is fine until any one of the smaller subsidiaries (a risky real estate financing entity, for instance) goes bust and potentially infects the holding company with a financial virus. After this, the unwinding of the whole entity could lead to a cascading descent for all of the subsidiaries, and this reinforces the fall of the holding company. The virus in a small entity ends up killing the whole financial institution. This precise situation happened in Japan, where the unwinding of the cross-holdings led to a financial meltdown. There were other causes, of course. But the cross-holdings accelerated a meltdown in a quick hurry. The unwinding was more toxic and more rapid than would have otherwise been the case.

An example of this is that by the early 1990s, when the bubble was deflating, the Japanese banks owned about ¥60 trillion in stocks of other companies. And this stock was used as capital. It was Tier 2 capital, but nonetheless was used as total capital calculations. This was all well and good as long as stock prices went up. This must have been the intention of the Basel Committee—to goose the stock market by allowing banks to use stock as capital.

In retrospect, this seems ridiculous. At the time, however, banks were up to their necks in “legitimate” Tier 2 capital, which was stock in companies in a deflating equity market. How much was ¥56 trillion at the time? It was more than US$400 billion, or about 25 percent of bank capital. In other words, one quarter of the bank capital to buoy the balance sheet of the nation's lifeblood of credit was predicated on the flimsy assumption that stocks always go up over time. Banks took a bath on these stocks at the same time that they were bleeding nonperforming loans.

The idea to use stock holdings as capital was a terrible one, but was brought to the banks by a sacrosanct organization with the international imprimatur of legitimacy—so it couldn't possibly go wrong, could it? The nonperforming loans in the Japanese economy, most of which came from real estate losses, caused a hemorrhaging of the capital structure of the banks, but the problem was made far worse when the stock market fell. The obvious question one must ask here is that even a freshman in an economics class could figure out that during an economic slowdown, nonperforming loans are bound to rise. At the same time, it is also clear that stock prices could just as easily fall. So capital is being eaten away at both sides at the same time. Why would the Basel Committee not see this coming?

This may not have been the direct cause of the Japanese meltdown of 1990, but many financial experts consider this cross-holding structure to be a contributing cause to the meltdown. To draw an analogy: An electrical short may have caused a fire, but the gasoline sitting next to a furnace on top of stacks of newspapers made it explosive. The cross-holding structure was kindling for the fire that started as LDRs for the banks rose dangerously above 1.0. By 1990, the LDR was pushing above 105 percent, and Japan had tapped out its extraordinarily large domestic savings base, a phenomenal sum of money created by an undervalued currency and the subsequent windfall in export earnings. This is mercantilism and is all too often present in these types of domestic liquidity bubbles.

At the same time, Japanese corporates were issuing bonds into Europe (euro-yen bonds) in order to fund a property market whose values were already sky high due to the exhaustion of domestic credit. Once again, we see that these forms of foreign borrowings to prop up a property market are especially dangerous, since they are, by their very nature, late to the party. They are Johnny-come-lately funders to a property party at three o'clock in the morning. Wholesale funding tends to end in disaster. For an excellent analysis of this, read Michael Lewis's September 2011 article in Vanity Fair called “It's the Economy, Dummkopf!” In it, he describes the poor wholesale funders in Dusseldorf who were left holding the bag at the end of the party. No one told them it was 3 A.M. and the party was over!

Basel II: The Rise of the AAA-Rated CDO Boom and Bust

Here's another example of how BIS rules on capital adequacy rules to ensure “prudential banking” backfired horribly and led to the blunder of the mortgage-backed security implosion in 2007–2009. In Basel II, another attempt to bring about prudence after the debacle of Basel I, the BIS laid down rules that basically said that banks can hold as many “AAA securities” as they like without any capital against them, as long as these securities maintained their AAA rating from two of the “big three” ratings agencies (Moody's, Fitch, or S&P). The end result is that bankers came up with so-called “AAA securities” in collusion with the ratings agencies to satisfy this quota system.

There is an interesting sidebar here. In all this mess, non-U.S. international ratings agencies cried foul. They said that this ménage-a-trois was a cartel that was, in effect, bringing about restraint of trade—a violation of the Sherman Antitrust Act. Furthermore, many clients of mine in China looked on in amusement as these ratings agencies made billions by rating any old paper being issued by banks as AAA. In fact, there were myriad stories of the ratings agencies actually handing over their own internal ratings programs (an astonishing breach of confidentiality) to the banks so that the banks could manipulate data. This created, in effect, a credit cooperative sponsored by the BIS. The BIS was saying that banks could produce as much of this paper as they wanted and have no capital against it in a mindless game of soviet quotas. This turned into a sham and earned the mock derision of many countries around the world.

Many policymakers watching from Asia and Latin America said, “What's good for the goose is good for the gander”—so countries in the emerging world decided to have their own ratings agencies that they could manipulate to their own ends, just as the U.S. system did. The breach of confidence by the West gave financial leaders in the developing world a sense of carte blanche to write their own rules when it came to ratings, regulations, and the like. It also makes Asian financial institutions groan a bit when they have to listen to yet another round of Basel III requirements. You can feel it in the room at Basel III conferences. Asian CEOs are less willing than ever to cooperate, because they have been witness to a corrupt and incompetent old-boys' club in the West, which has caused a calamity from which is has been difficult to escape. Why should Asian bankers cooperate in yet another hare-brained scheme?

In Basel II, the fundamental underpinning was that the AAA securities that were blessed by these ratings agencies happened to be mortgage-backed securities (real estate prices never go down, right?), which could be placed on the balance sheet of the banks as inventory and as investments without a single dollar of capital against them. This means that there was virtually zero chance that they would default and need to be written down at the expense of scarce capital. These were “bulletproof” mortgages from a diversified number of ZIP codes across the country that could withstand any small recession. Real estate prices never fall in all ZIP codes in the United States at the same time, right? The banks blindly went along with this charade, never asking a simple question: “How could there be more than 50,000 AAA-rated securities in the United States when there were only 7 companies in the entire country that had an AAA rating?”^*

As a result, a bubble in AAA-rated securities emerged on the balance sheets of banks globally and at the same time. (Is it preposterous to say that this is similar to Stalin telling the whole country to plant wheat, or Mao telling the whole country to make a steel factory in their backyards? Think about it!) No banker needed to ask whether these really were AAA-rated securities, since the ratings agencies said so and since the BIS said it was okay to have as much as you liked. So, vast amounts—literally trillions of dollars' worth—of these AAA-rated securities were created and placed on the balance sheets of financial institutions without any capital against them. There was no need to do so, because the BIS said so.

These securities were placed all over the country and then went overseas to foreign central banks. These central banks were searching for safe yield, and these AAA securities offered security (they were AAA after all) and yields of 85 to 100 basis points over other AAA-rated government securities. When these securities were suddenly downgraded simultaneously in the summer of 2007, there was both a glut of not-unsold inventory on the balance sheets of banks and vast holdings that many institutions did not and could not hold any longer. Central banks in Taiwan, China, Japan, Hong Kong, and other countries found themselves with toxic assets. They simply couldn't tell which of these assets were good and which were more akin to counterfeit currency. Furthermore, these banks suddenly needed much more capital to hold against these securities, which were downgraded to junk.

So, the banks all went over the cliff together (once again) as they followed the Basel II rules. There is a bigger problem here. As the banks put more and more of these AAA securities (numerous variations of mortgage-backed securities) on the balance sheet, no one asked just how these would be funded. These were an asset of the banks—a product that was for sale. They needed to be funded on the liability side of the banks. Most of the banks that dealt in this toxic world were investment banks, which were barred from taking deposits. Only their commercial banking arms could take deposits. So, what did these investment banks do? They lobbied for the abolition of the Glass-Steagall wall between commercial banks that could take deposits and investment banks that could manufacture “AAA-securities.” They lobbied the government to allow Federal Deposit Insurance Corporation (FDIC) deposits to fund these toxic securities and other dubious investment banking or proprietary positions.

One investment banker whom I know called it a kind of counterfeiting operation. By 2006 or so, many bankers who were manufacturing these securities smelled a multitrillion-dollar rat. It was hard for even the bankers inside these financial institutions to tell the difference between the good CDOs and the fraudulent CDOs; they were all mixed together. Almost 20 percent of these alleged AAA securities eventually became worth zero; in other words, one in five blew up. Who cares? As long as Basel II rules were being followed, the game was on. And the party continued. If the ratings agencies said they were AAA-rated, that was all that counted.

As long as this game continued, bankers could make vast fees and continue to generate these securities. However, when there was a hint of small amounts of counterfeit CDOs swirling around, the smart insiders became increasingly uncomfortable and forced the issue by complaining to the Federal Reserve, the ratings agencies, and the SEC. It is a good guess that the arm of the ratings agencies was twisted enough for them to start downgrading these securities in the summer of 2007. This was the beginning of the end for the house of cards. By the summer of 2008, one year later, the assumption was that everything was counterfeit unless proven otherwise. This is what hastened the collapse. No one—not even the smartest guys in the room—knew what was good and what was worthless.

So, these banks issued billions of dollars of debt and availed themselves of the balance sheets of their parent banks, which had (literally) trillions of dollars of deposits. These included banks like Bank of America, Citi, and J.P. Morgan Chase. Even this vast amount of savings was not sufficient to accommodate the mortgage-backed securities to fund the real estate boom.

Even though the numbers showed that the “capital base” of the banks was sufficient to accommodate losses, the LDR of the system was ballooning out of control, and no one was watching this because the LDR was not a remote consideration of the BIS. Indeed, Basel III does not envision any kind of loan/deposit cap.

Yet it is not the leverage levels of the banks that tend to show up problems. It is the LDRs that tend to be blood pressure indicators. LDRs are the purest indication of liquidity, and liquidity is everything. Liquidity in the form of deposit liabilities that can buy time during difficult periods is the key to survival. HSBC had a relatively prudent LDR during the 2008 madness and did not need a bailout. So did Standard Chartered. So did the Canadian banks. Those banks with liquid balance sheets were safe. Those with LDRs of 1.2 or 1.3 were all crushed, and the equity was wiped out. These banks include all Irish banks, all Greek banks, Spanish banks, many U.S. banks, and all of the U.K. commercial banks (which were taken over by the government). You get the point. Liquidity is solvency, and do not let anyone else tell you differently.

So, let's take a look at a perfectly fine document like the Basel III Handbook, published by Accenture (www.accenture.com/sitecollectiondocuments/PDF/Financialservices; registration required). It has dozens of pages of new arrangements for capital adequacy aimed at creating a prudential framework for banks in a new environment. Go through the document and you will not find one single paragraph on something as fundamental as the LDR. Deposit funding is all about what creates the liquidity to allow banks to remain solvent. The long-term debt that too many banks have used (as well as convoluted derivatives) does not belong to the bank; it belongs to bondholders. In this sense, Deutsche Bank has ended up with a balance sheet that is only one-third funded by deposits. Two-thirds of this balance sheet is funded by bonds. The same is true of other banks. What happens when regulators like the UK FSA (the financial markets regulator of the UK) force the commercial deposit–taking arm of the bank (with high-quality deposit funding) to be separated from the investment bank, which is largely bond-funded. The investment banks will undoubtedly be treated as a separate credit and will likely be downgraded. This is a problem for future funding.

In too many ways, capital adequacy ratios (CARs) are a shell game. They allow national banks to play a host of “risk management” games, which offer a sense of safety but which often ignore the ways in which these risk assets are funded. Liquidity (deposits) is the water that makes the assets of a bank grow. Capital is merely fertilizer for the balance sheet. It is vital, but cannot have an effect without the water provided by the credibility that causes us to deposit money in the bank and allow it to remain there. The water of this delicate financial ecosystem is savings (deposits liabilities of both individuals and corporates that can be turned into loans). Using assets/capital ratios ignores the liability funding issue completely. It has caused banks to ignore the vitally important role of deposit funding and instead has caused a focus on quasi-equity and bond funding, which introduces a higher level of risk because these bond portfolios are, after all, leverage.

This capital is very expensive. It must be rationed very carefully. Risk systems must be put in place to ensure that profits can be generated from the spread between the cost of savings (deposit liabilities) and the rate of return on loans (assets) that the bank receives. The spread between these two in turn creates more capital over time. The problem here is that lopsided investments in assets can become problematic when too many banks have too many of the same assets at the same time. This is likely to happen with government bonds as investments on the asset side are backed by too little real capital and instead are backed by long-term bonds on the liability side. This time is over, and this gargantuan monstrosity is very definitely being dismantled.

This is what happened with the global financial crisis—too many banks had committed their balance sheets to manufacturing or holding mortgage-backed securities because the Basel II regulations steered too many banks into doing this. And they were all doing so at the same time. The entire financial ecosystem was motivated to move toward a type of Soviet collectivization or mandated “crop rotation” for all entities all at the same time. The result was a windfall of one type of financial crop—the mortgage-backed security. This is akin to the entire Midwest of the United States deciding to plant only corn because corn prices were high and the CME (Chicago Mercantile Exchange) told the major agricultural producers in the Midwest that it was to their benefit to plant corn. The result in the next season would undoubtedly be a collapse in corn prices. This is why the price of mortgage-backed securities collapsed: Everyone was planting them because the BIS and Basel II said it was a smart thing to do. As we look at Basel III, let's see what we are now setting ourselves up for.

Furthermore, the new Basel III rules are astonishingly punctilious. There are a dizzying assortment of slices that make up the capital structure. The level of detail is unrealistic when it comes to the day-to-day functioning of banks. Many CEOs of banks find this level of exactitude laughable. It is as if those who are writing these rules are divorced from the realities of banking. In addition, as more detail is required for understanding the rules for what kind of capital applies to what kinds of circumstances, a great deal of wiggle room is created to search for exceptions and ways around the rules. In essence, the Basel III rules create quotas for capital. Quotas always create long queues, and long queues create corruption. Quotas make for corruption.

In this way, we can see that the BIS acts as a kind of central planning commission that decides which products the banks should hold as inventory and sell. It is a perverse form of central planning that tells all the global banks what to do at the same time. Surely this cannot be a good thing. And yet it continues through one financial bubble after another.