Basel III, Black Swans, and Uncle Larry

The Basel Accords I, II, the ariving III, and the future IV all exist because of a paradox. Banking activities are considered so essential to the economy that governments through the agency of central banks that they are not allowed to fail. Banking activities that would cause them to fail are constrained by provisions of the Basel accords and it subsequent amendments if there are perceived as risky. The very banking activities that are constrained by the Basel accords are essential to the economy.

Banks keep relatively quiet about this. They often complain about the limits placed on their activities, but do not complain about cheap Fed funds, various liquidity programs, and outright subsidies they receive in dire times. They know when to pipe down. Governments pander more to the public’s concerns about excessive risks than the benefits that intrinsically risky banking activities offer to the larger economy. So governments tell banks in increasingly exact detail what they can and can’t do. Banks are preserved, continuing to take risks but only Basel-complaint “safe” or adequately provisioned risks. These safe risks either have an innate risk-weighting that isn’t that risky or they must be hedged by offsetting government securities (convenient much). All very swish except for the economy as it loses access to funding for its essential and risky activities.

The justification: the “Black Swan”. You first found this bird in the book by Nassim Nicholas Taleb and these cats have likely not even read Taleb’s admittedly engaging book about the effects of kurtosis on life. The black swan ultimately serves as a convenient excuse. Banks that lost a lot of money, politicians and regulators that need to shift blame, and academics that don’t want to be called idiots all quickly adopted the black swan defense. The argument is just the last refuge of those who really should have seen the financial crisis coming.

Being a good banker, Uncle Larry couldn’t stand fads and fashions, and he had an amazing crap detector. He couldn’t stand it when I talked about “The Black Swan”—the image for financial crises as completely unpredictable, extremely disruptive, once-in-a-lifetime events. The Basel Accord exists to make sure black swans don’t happen. It’s taken on a life of its own: an evolving body of regulations, disconnected from reality, ever-more-burdensome, never-really-effective.

Trouble is these sorts of shocks hit the world every ten to fifteen years, not once in a century or even once in a lifetime. Seriously, check the list:

  • Over 50% of all US corporate bonds defaulted during the period of 1870-1879

  • The global banking system collapsed in 1907

  • Financial collapse associated with World War One and the Russian Revolution

  • The 1929 market collapse and the Great Depression

  • World War Two-associated market carnage

  • The 1970 to 1974 global equity market collapse due to the OPEC oil crisis

  • Utter collapse in commodity prices post 1987

  • Asian currency crisis of October 1997 and associated defaults in Russia, Thailand, Indonesia, Mexico and Argentina (10 year anniversary of the 1987 market collapse)

  • The “Tech Wreck” bubble of 2000

  • The Global banking system nearly collapsed in 2008

People like my Uncle Larry—who saw a number of such crises over their careers—would call black swans and the cottage industry developing around it total nonsense. Uncle Larry really did pull no punches. He once told a high official of a certain banana republic expecting a bribe that his company didn’t offer or pay bribes. The jack-booted klepto was so impressed by his integrity that he signed off without any cash under the table. He had no time for games and excuses.

Even if the proximate causes of these financial collapses are unknowable, and precise timing of them is impossible, the 10-15 year regularity of market crises is undeniable. The only possible difference between the most recent events and some of its predecessors is that this one has been exported around the world by the global financial system: a difference of degree and not kind. Even global crises happen often enough.

Financial collapses are the unavoidable product leverage applied to an illusion of certainty. They are a part of the life cycle of any complex adaptive system. New and misunderstood products behave in a certain way when they first enter the credit market. They grow into a large and normal part of the credit universe. They show spread moves like any other part of the complex. Leverage is applied. Volatility increases when the cycle turns.

The natural, time-honored, reasonable solution is the bankruptcy of the most exposed. Central banking increasingly exists to make this unlikely. Basel exists to make sure that central banks don’t have to intervene in such ways. Banks take only prescribed risk, peripheral to what matters to the economy. This is the symbiosis between government and finance which long predating Basel is laid bare.

It is not bankruptcy, but regulation that has a deadening effect reaching to on society itself. The clash between authoritarian and democratic regimes in World War I generated fears about the end of the Enlightenment. The Great Depression led to serious consideration of alternatives to free society. During World War II it seemed possible that genocidal regimes could gain global supremacy. Communist revolutions, the Korean War, the Vietnam War and the Indonesian genocide made much of the world un-investable. From 1950 to 1990, there was a constant threat of a global nuclear holocaust at any time. Now every email, phone call, and blog post is potentially monitored for subversive activity. The collective mentality influences both markets and societies in general, creating vicious, self-reinforcing feedback.

The infinite series of Basel accords likely converges to something close to zero economic activity. Such regulations never solved anything. What solves the problem is being keenly aware of life’s uncertainty and the possibility of ruin. Yet—like Uncle Larry—never, even in the darkest hours, losing the taste for life and its risks. He went out smiling.

#baseliii #blackswan #banking #couragetothelast

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