Monday, November 15, 2010

Basel 3 may hold the key to monetary reform

If radical monetary reform is too much too soon, perhaps a little-discussed part of Basel 3 holds the answer.

Monetary reform is rapidly gaining the public’s interest, something the Basel rules on bank capital adequacy have never quite managed. But perhaps Basel has a special role to play in helping monetary reform come of age.

Calls for monetary reform are being led by a small band of unorthodox economists whose ideas are catching on in these austerity days.

At its heart is the realisation that today's money is in fact credit, or debt, and it is mostly created by private banks when they add digits to people’s bank accounts.

As a plethora of online presentations explain (type “how banks create money” into google), it’s illegal to print bank notes but not to create digital credits – the online equivalent - as long as you’re a bank and you follow the rules.

This is how fractional reserve banking works in a digital age but the realisation has potentially big implications for politicians fighting deficits and stagflation.

Before the financial crisis (and since), banks pumped money into the economy by creating a lot of credit, for example gearing up on asset-backed securitisations and leveraged loans. This created profits for the financial sector through commissions and by gaming capital rules to drive up returns on equity and therefore bonuses. Not all the lending was helpful, as the mortgage foreclosures in the US testify.

Monetary reformers argue that by allowing only the government to create money, lending of dubious economic value could be reduced and the power of money-creation wielded by the financial industry returned to the people. National deficits could be tamed more quickly and real economic activity boosted without always having to maximise returns on bank equity first.

Instead of financing secondary private equity buyouts or sub-prime mortgage-backed collateralised debt obligations, the credit system would fund job creation, innovation and production.

This is exciting and revolutionary but getting it done would be like turning a fleet of super tankers in the fog.

First, someone has to make the case for what many would consider economic heresy. This is beginning to happen with big names such as Paul Tucker and Martin Wolf commenting openly about how private banks create credit.

Then, some workable policy ideas have to be developed. A host of campaigners such as Ellen Hodgson Brown and the nef’s Josh Ryan-Collins are working on this, with Hodgson Brown suggesting that the near-bankrupt state of California could solve its problems by creating a state-owned bank, as has been done successfully in North Dakota.

Campaigners would then need to explain to businesses why the government would do a better job than the current crop of private bankers, and convince politicians that nationalising credit creation is not the economics of soviet Russia.

I’ll leave that to them but assuming they can, now seems like an excellent time for a monetary experiment, with several private banks in state hands after the crisis. Unfortunately, sensible proposals such as the nef’s call for RBS to be turned into the Royal Bank for Sustainability have made little headway.

This illustrates the biggest impediment, political economy. No private industry has ever given itself up for voluntarily nationalisation, which is what this reform really means. Natural monopolies like railways fought tooth and nail against nationalisation in the last century; it’s hard to imagine today’s politically connected banks handing over the keys to the Treasury, barring a bigger financial catastrophe than the last.

So here’s how Basel 3 could help monetary reform to make its own case, without any financial revolutions or crises.

Imagine a spectrum with full monetary reform at one end, in which only governments can create credit, and the current system at the other, in which banks create money where they like, subject only to central banks’ distant attempts to direct lending through interest rates and the capital adequacy rules.

An intermediate step would be to let governments alter the Basel risk weightings to suit their own national economic and industrial policy.

At the moment, risk weightings are determined by an opinion – not always reliable – about how risky an asset is (a concept that is itself deeply flawed, see here for further reading). If a ratings agency or the bank’s internal risk managers think a loan is “safe”, then the loan is assigned a low risk weight, say 20%, which reduces the capital held in reserve against the loan. But if the loan is deemed to be dangerous and weighted at 100% the bank must hold five times as much capital to make the loan.

This means banks create credit where they can get low risk weightings, such as AAA sub-prime debt and monoline-insured ABSs, and not where they might earn high interest margins and hopefully create jobs, such as small business lending or trade finance. The current system almost has an in-build discrimination against economically useful lending.

To kill two birds with one stone, campaigners need to persuade the government to override Basel-approved risk weightings on certain types of lending to suit their own, specific policy goals. Interventions would need parliament approval and be communicated along with the policy goals, such as boosting green investment or helping businesses in a certain sector or region.

Banks would still be the ones creating the credit, deciding interest rates and other conditions, but they would be influenced by the logic of national economic interest instead of flawed and complicated capital rules with no obvious link to economic outcomes.

There would need to be accompanying reforms, in particular a tough overall leverage ratio to prevent excessive risk build-up, and a mix of structural separations and resolution plans to manage contagion and bailout costs if a bank were to overdose on juicy, patriotic greentech loans and get itself in trouble.

It could be introduced in just a few sectors at first, until banks and businesses see the effect. Once people start to see the benefits and note the absence of soviet gulags, it might be possible to have a wider debate about where the power to create credit should lie in a modern, democratic economy.


  1. As I read your post, Greg, you are proposing that some decision-making authority other than the Basel Committee and its influence on legally mandated regulators, perhaps a bank's own internal risk management procedures, assign a risk-leverage factor to each loan in determining how far a bank can expand its loan portfolio.

    Doesn't that already happen in practice? IOW, don't the regulators determine after loans have been made whether a bank has kept within "good practice" (as measured against rules of thumb proffered by Basel for aggregated loan categories) and, if it hasn't, negotiate with its leadership group a "correction" process.

  2. Not quite, I'm proposing that national governments do this.

    Ideally, you'd raise all risk weights to 100% as per Per, then go a step further by allowing governments to lower specific 'hot spot' weightings for banks in their country, such as for lending on green tech, infrastructure, regional or SMEs, according to the political agenda of the day.

    It's a bit like using fiscal measures to influence lending but with capital instead of tax. It could plug into existing bank management systems but leave banks to make their own risk assessments.

    Instead of setting risk and return to maximise ROE per Basel rules (which act like a tax on growth and do not stop risk build-ups), banks would trim their balance sheets according to a mix of their own commercial/prudential judgement and the public policy goals set by the govt.

    It replaces capital discrimination based on dodgy risk assessments with discrimination based on beneficial public policy goals, making banks useful again, if you like