ENDGAME NOT READY TO END
EDU DDA June 25, 2024
Summary: The latest update on the ongoing saga of Basel’s so-called Endgame. Recent reports suggest the Federal Reserve is willing to substantially scale down some of the proposals. Questions remain as to whether the other regulators will go along. While the discussion continues, we have more projections on potential effects and their costs from a couple of sources. It isn’t so much the simulated measurements they’ve produced which should grab the attention of everyone involved, but why the estimates turned out the way they did.
It was reported yesterday that officials at the Federal Reserve, at least, as expected are conceding some of the so-called Basel III Endgame. I last wrote about this in early March describing the proposed outlines and what various regulatory bodies around the world are aiming to accomplish:
If anything, last year’s banking crisis ably demonstrated how feckless these regulations are. Everyone from SVB to First Republic and the forgotten failure of Credit Suisse were well in compliance on every single angle – LCRs as well as capital ratios. Rather than get more detailed, you can understand to a degree why officials would instead opt to just increase the buffers and see if that works.
Regulators therefore try as much as they can to develop what are really cheats. The LCR, or liquidity coverage ratio, was one, as would be Basel Endgame™ and its new proposed RWA guidelines. They are doing nothing more complicated than to require more capital be held, effectively making for a larger capital buffer, if only because they have no other idea how to treat complex dealer balance sheets.
As I wrote back then, once you realize these aren’t actually banks then trying to regulate them as such is impossible. Most are hedge funds with special privileges though we do have to take seriously their dealer books and capacities; the latter are absolutely essential to the modern monetary operation even if authorities continue to be confounded and confused by them.
Ledger money was first developed in the absence of other forms, a workaround to get around repeated hard money shortages. As more elaborate and complex mercantile then industrial economies developed, they quickly realized the need for monetary mobility as an essential ingredient, a feature rather than bug of ledger money frameworks.
The two are inseparable, the demand to mobilize funds in whichever form they may take. Financialization has become a bad word to sound money advocates if for some sound reasons. But practical experience shows conclusively money has to move and there has to be some incentive structure for often complicated intermediation required to move it.
When dealers act they are a marvel of complex operation, an integral aspect to spreading legit and sustained wealth around the planet. It’s all the other crap we can do without. The system’s problem is being able to separate the one from the other when regulators still think of these firms as the fractional reserve type depositories they haven’t been in generations.
Basel Endgame™ is attempting to pull all this under a common umbrella by urging simplicity so as to be able to overdo it:
Though the current Endgame™ seems dead, this idea isn’t going away. Authorities simply have no idea how to regulate what banks are so they’re going to press for bigger and bigger buffers, leaving the only question to just how big. The effect is, at the very least, uncertainty which, far be it for me to defend banks, means restraining balance sheets long before any intended restraint and for unnecessarily arbitrary reasons.
To be perfectly clear, I’m not advocating we let the banks go back to their cowboy days even assuming that is possible (it almost certainly isn’t). However, we can’t continue to impose regulations made for banks on institutions that aren’t those. This doesn’t help anyone.
What Bloomberg reported yesterday is that the Fed, at least, out of the US government triumvirate (the FDIC and OCC being the other two) has agreed to dial back the umbrella.
The Federal Reserve has shown other US regulators a three-page document of possible changes to their bank-capital overhaul that would significantly lighten the load on Wall Street lenders, according to people familiar with the matter.
The revisions would walk back key parts of the landmark proposal — including one that might have had a large effect on big banks with sizable trading businesses, said the people, who asked not to be identified discussing details that aren’t public.
Again, calling them lenders isn’t helpful because they don’t really make loans as much. They use their balance sheets for various purposes, though largely where there are loans to convert them into mass-produced packages more easily mobilized around the eurodollar world.
Various central bank officials had already publicly expressed their own misgivings, as I cataloged in that previous DDA. This isn’t actually all that difficult to understand. Forcing banks to hold even “more” capital would make their already inefficient balance sheets even more so, and since most of what they do now is tied to dealer functions that’s what would end up suffering the most.
One roadblock to understanding why this would be a huge mistake is the widely held idea banks have been excessively expanding for the past decade and a half and doing it because of giveaways from QE to interest rate policies. The era of “easy money” the Fed is always talking about has in reality been anything but.
The supply shock era only amplified this misperception - as did last year’s bank failures. Public and political perception is fixated on the notion of unrestricted cowboy behavior. The irony is whatever bubbly activities showed up the past few years (entirely absent from the 2010s) was entirely due to government distortions, especially the CARES Act and the American Rescue Plan Act of 2021.
Contrary to conventional thinking, balance sheets have been so scaled down and restricted they are already surpassed in many ways by unrestricted non-bank participants. Who is buying all these Treasuries the government keeps issuing? Hedge funds and other private balance sheets. Any credit expansion which has taken place is coming from the outside.
But the triumvirate has no authority over the outside, either outside of banking or just as important outside in the offshore-lands.
This just makes dealer capacities all the more important. The way in which all these different kinds of financial firms work together – or don’t – is through those functions, the ability of these specialized constructs to analyze, understand, then integrate various credit/money needs. To propose widespread further restraints on them all because SVB was overoptimistic about the 2021 economy while understating the likelihood it would bleed windfall cash much faster is nonsense, though typical of regulatory behavior.
Economists at the Fed love and respond to econometric analysis. Several programs have been put together in recent months attempting to quantify the boundaries any impact Endgame™ might have more importantly on broad economic growth and potential. One of those from audit firm PwC suggested long run expansion could be cut down by a quarter.
Assuming the economy is able to manage the same pitiful 2% per year, their models find around a 56-bps reduction in that rate – not per year, every year.
The primary reason for this reduction comes from the realization banks are already operating at their “optimum” capital capacity. In other words, there is no more efficiency they might be able to deploy which could then counteract the heightened restrictions.
Regulators have assumed that higher capital buffers would reduce perceived and modeled volatility, meaning a material discount in the chances for another major crisis or even minor ones like we’ve been experiencing entirely too frequently. With lowered possibilities for larger downside potential, banks could theoretically free up more capacity they’ve otherwise been holding back as their own risk buffer.
This idea makes several wide assumptions, beginning with the one that somehow higher capital ratios (or even more capital itself) equates to lower chances of major problems. The big failures of the 2008 era as well as those last year – including Credit Suisse – were all well above every minimum set out by banking authorities. Making those minimums higher doesn’t necessarily or even likely reduce “future volatility.”
As PwC’s report puts it:
Reviews of academic literature suggest that U.S. banks are currently operating at or near optimal levels of capital. Accordingly, negative effects on GDP growth would likely not be offset by the long-term gains achieved by reducing the probability of a financial crisis as the NPR assumes.
…
Building on a previous review, the academic literature on optimal capital requirements suggests that large banks are already operating at or near levels of optimal capital. The assessment in this paper provides additional context for considering the trade-off between assumed gains from greater financial stability, which may have largely been achieved by current capital levels, and the incremental costs to economic growth as measured by GDP.
These new regulations, therefore, may not add much if anything; failing to contribute to reducing the chances of further systemic volatility in the first place. If that’s true, then what’s the point of Endgame™ before even asking the question about bank capacity?
Moreover, the current proposed regulatory changes are aimed squarely at dealer activities which makes no sense given their importance. What I wrote in March applies here, basically since authorities don’t know what dealers do let alone how (or why) they do it, they are attempting to control what they can’t via blunt means that will only further harm these already severely impaired activities, those the system vitally needs just to operate at its current minimal levels.
To force them to even minimal-er is actually courting more danger and risking more economic drag.
It is all downside with increasingly little chance of achieving anything let alone the lofty aims of living up to Janet Yellen’s “there will never be another crisis in my lifetime.” However, that doesn’t mean bureaucrats won’t go through with this anyway. Cost-benefit isn’t really their primary consideration.
That’s all about appearing to do something. Banks fail and naturally bank regulators feel they need to respond if only to cover their own backsides. They don’t necessarily care much about any real impact; just look at Dodd-Frank and Basel III which were judged huge successes because they had purportedly avoided a second Lehman Brothers and the political headaches something like that would’ve given authorities.
With that in mind, other US regulators don’t appear to be so willing to reconsider Endgame™ as the Federal Reserve. Back to Bloomberg:
Barr already has met with the heads of the Federal Deposit Insurance Corp. and the Office of the Comptroller of the Currency to discuss lowering the capital hike, according to people familiar with the matter.
Key OCC and FDIC officials were open to walking back an important part of the proposal — known as market risk — but have indicated privately that they would resist any capital increase that they consider too low, some of the people said.
This is why getting interest rates wrong and believing the economy has been generally healthy apart from the pandemic and its lockdowns is itself harmful. The post-crisis monetary system globally has been marked with serious fragility not resilience, and it has taken a toll on the global economy the entire time.
Low yields tell us why: money and credit don’t circulate as much or as actually needed. Tight money even if the Fed has made bank reserves (which aren’t money) abundant all along the way. Neither the central bank’s policies and actions nor additional bank regulations have actually produced the desired results. The banking system has withered to the point that its major contribution these days is entirely dealer intermediation.
So what do authorities propose? To make that even more difficult simply because their prior regulations and existing Fed tools couldn’t account for SVB– when what happened to SVB didn’t really have much to do with anything being proposed here.
Logic has no place in bank regulation, which is actually standard practice going all the way back to the beginning. There are problems with these institutions, for sure, just none the government ever seems able to fix. Like central banks, regulations only appear to be effective when banks are doing what banks do.
Nowadays, what’s left of them is what dealers do.
Setting aside all considerations of cost and introducing even more inefficiency, the world’s governments are going forward anyway. The only question is how much they end up intruding, not whether they will. They’ve put too much into the effort to back all the way down now. I dare say Endgame™ isn’t quite near its endgame.
