Basle III Means There is Less Need for the FSA to Micro Manage the Mortgage Market

Posted on 14 September 2010 by Ray Boulger

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There is a fine line between appropriate and overly onerous regulation and after all the horse trading it is far from clear that the proposed Basel III rules have drawn that line in the right place, although after the huge bail out costs a significant increase in banks’ capital adequacy requirements was clearly necessary.

As usual with regulatory failure we now have a situation where the various regulatory authorities, including the new EU super regulator and the FSA, are over-reacting, throwing the baby out with the bathwater and proposing measures designed to deal with the problems of three years ago, whereas the next banking crisis will probably be caused by something different. That is not to say the problems now highlighted don’t need to be addressed, but it does mean we can’t be complacent that these new rules will prevent further failures.

Most banks have already increased their core capital in response to the crisis and as a result of pressure from their home regulator. UK banks have also hugely tightened lending criteria, reflecting the ongoing shortage of funding and pressures to repay both the emergency borrowing from the Bank of England and to refinance wholesale borrowing as it matures.

The new Basel rules will permanently increase costs for all banks, and hence their customers, assuming they can get a loan agreed, but as the major UK banks already meet most, if not all, of the Basle III requirements, in practice these extra costs are already largely factored into current lending terms. The new rules will prevent backsliding when conditions eventually improve but there is room for individual countries to exercise some flexibility in interpreting some of the rules and so Basle III will not result in a completely level playing field.

The Basle committee is effectively saying that it considers these new more onerous rules are needed to ensure stability of the banking system but it has delayed the requirement for full implementation until 1st January 2019, primarily because of pressure from Germany and the impact the new rules will have on economies which are still a long way from being out of the woods. As the major British banks already have capital ratios well in excess of the new minimums the new rules will broadly speaking institutionalise the more conservative basis on which banks are now operating rather than further increase costs.

It is of course possible we will have another banking crisis over the next 8 years before the new rules are all fully operational. If this doesn’t happen it rather begs the question of whether all of the new tighter rules are needed. However, as most banks are likely to meet all the new Basle III requirements well before the deadline this will be a difficult line to argue either way but a reward for those banks which get there early is likely to be cheaper borrowing costs in the wholesale markets, allowing them to either offer cheaper loans or increase profit margins, or a combination of both.

The tougher capital adequacy requirements will reduce banks’ ability to lend on an ongoing basis and increase the cost of what they do lend, both of which factors will reduce new economic activity and hence result in tax revenues growing more slowly. Hence, one impact of Basle III will be that it will take longer for Western Governments to bring their budget deficits into balance, or at least to an acceptable level of deficit. Against that it reduces the risk of huge amounts of public money being again needed to shore up those banks considered "too big to fail," or "systemically important" to use the term the Basle committee favours.

So far Basle III has not included any new rules on minimum liquidity levels or made any reference to mark to market accounting. If the proposed rules had been in place 2 years ago Northern Rock would almost certainly still have failed as its immediate problem was not lack of capital but lack of liquidity.

In the depth of the crisis, instead of mitigating problems the mark to market rules exaggerated them as in a market where there were virtually no buyers for certain assets the value of those assets had to be marked down to comply with these accounting rules. That weakened Balance Sheets, resulting in some forced sellers. As a result prices fell further, which then required further mark to market write downs. Catch 22!

A good example is the residential mortgage backed securities (RMBS) market. This type of asset had previously been classed as a liquid asset but overnight the market in these securities virtually dried up. Hence a double whammy – such assets were no longer liquid and if one could establish a value it was much lower. This all happened despite the fact that the vast majority of UK RMBS continued to be 100% performing and are highly unlikely to ever result in any losses for their holders. U.S RMBS are a different story but this merely demonstrates that when the market panics about an asset class even quality investments get caught in the maelstrom.

After the FSA’s recent draconian proposals for mortgage lending in the Mortgage Market Review I was somewhat surprised to see its Chairman, Lord Turner, comment that "the agreement amounts to a major tightening of global capital standards and will play a significant role in creating a more resilient global banking system." I suppose as Chairman of the FSA he has to say something like that but if he really believes Basle III produces such "major tightening" at the macro-prudential level, surely that means there is much less need to micro manage the mortgage market!

Categories: Property market, Bank of England, Mortgages, Regulation

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