Rocky Vega

So many explanations have been offered for the financial crisis, then reheated and reexamined, that it’s nearly impossible to imagine a new theory worth considering. However, Jeffrey Friedman of the Cato Institute has found one. He looks at a little-discussed regulatory mechanism that incentivized banks to put a disproportionate share of capital into what turned out to be some very toxic assets.  

Friedman explains in the Cato Policy Report:

“In 1988, financial regulators from the G-10 agreed on the Basel (I) Accords. Basel I was an attempt to standardize the world’s bank-capital regulations…

“It differentiated among the risks presented by different types of assets. For instance, a commercial bank did not have to devote any capital to its holdings of government bonds, cash, or gold — the safest assets, in the regulators’ judgment. But it had to allot 4 percent capital to each mortgage that it issued, and 8 percent to commercial loans and corporate bonds…

“The United States implemented it in 1991 […] Ten years later, however, came what proved in retrospect to be the pivotal event. The FDIC, the Fed, the Comptroller of the Currency, and the Office of Thrift Supervision issued an amendment to Basel I, the Recourse Rule, that extended the accord’s risk differentiations to asset-backed securities (ABS): bonds backed by credit card debt, or car loans — or mortgages — required a mere 2 percent capital cushion, as long as these bonds were rated AA or AAA or were issued by a government-sponsored enterprise (GSE), such as Fannie or Freddie.

“Thus, where a well-capitalized commercial bank needed to devote $10 of capital to $100 worth of commercial loans or corporate bonds, or $5 to $100 worth of mortgages, it needed to spend only $2 of capital on a mortgage-backed security (MBS) worth $100.

“A bank interested in reducing its capital cushion — also known as ‘leveraging up’ — would gain a 60 percent benefit from trading its mortgages for MBSs and an 80 percent benefit for trading its commercial loans and corporate securities for MBSs.”

As Friedman describes above, the regulations intended to improve the operations of the banks instead put the wheels in motion for a financial mess. It shows how oftentimes meddling in a system is worse than leaving it alone.

For more details and insight into the causes and consequences of the financial crisis visit the Cato Policy Report’s coverage of a perfect storm of ignorance.

Rocky Vega

Rocky Vega is publisher of Agora Financial International, where he advances the growth of Agora Financial publishing enterprises outside of the US. Previously, he was publisher of The Daily Reckoning, and founding publisher of both UrbanTurf and RFID Update -- which he ran from Brazil, Chile, and Puerto Rico -- as well as associate publisher of FierceFinance. Rocky has an honors MS from the Stockholm School of Economics and an honors BA from Harvard University, where he served on the board of directors for Let?s Go Publications, Harvard Student Agencies, and The Harvard Advocate.

  • http://dailyreckoning mike

    …Q…WHAT CAUSED THE FINANCIAL MESS…A…NEW TECHNOLOGIES ARE DISPROPORTIONATELY ‘HOARDED’ FOR MILITARY USE AND KEPT FROM CIVILIAN EVERYDAY USE…THUS OPPORTUNITY FOR INVESTMENT GROWTH AND ADVANCE GRINDS TO A HALT…now, wherz my nobel baby?…

  • sierra

    I’m a registered no-partisan voter….disgusted with the actions of both major parties….but we have to remember that we are a “political economy” not just an “economic” economy.
    The present crisis can be argued ad infinitum over minutia but the bottom line it can be attributed to the quest for power, greed and a lack of business ethics.
    A decent study of the history of banking in the US will give you a clue.
    The present administration, however you rate it, inherited the worst of the worst policies administered (by both parties genuflecting to $$$$$) too much in the interests of “the invisible hand” rather than a LONG TERM vision of a truly progressive society. Until we “free” ourselves from the notion that the “market” forces will cure Society’s problems we will continue to wallow in the mud of mediocrity.
    End of story.

  • La buena vida

    Free markets are too blame? What frickin universe do you live on? Free markets haven’t been in play for a very long time except for the small business owner who must put up with increased regulation, tax and interference. Then when they are bankrupted they are liquidated. They aren’t too big to fail. I say liquidate the banks(someone will buy their assets), liquidate the states, liquidate the feds(hell, sell the Grand Canyon). That will get the “progressives” attention. You want all these gubmint programs then pay for them… now!

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