IGNORING LESSONS LEARNT

My most recent column in the French daily paper Le Monde : Le risque systémique court toujours. As usual the translation is due to Bénédicte.

Lehman Brothers’ bankruptcy, on September 15, 2008, and its aftermath – more than one trillion dollars being injected into the financial system – have caught people’s attention about financial firms “too big to fail”, i.e. that their bankruptcy is bound to automatically cause the downfall of the entire financial system.

On June 15, the Bank for International Settlements in Basel, that is to say “the central bank of central banks”, announced the measures it is recommending for these banks, labelled in its own jargon: “Global Systemically Important Banks” or G-SIB.

The philosophy underlying the Basel agreements consists in requiring that banks hold sufficient reserves to cope with the losses they may endure. For obvious reasons, the figures required from G-SIB are on the rise: in addition to reserves ranging from 7 to 9.5% of the capital at risk, the G-SIB will provide additional reserves ranging from 1 to 2.5% of capital properly so called (Tier 1), depending on some aggravating factors: size, interconnection with other G-SIBs, difficulty for other institutions in taking over from them should they default, global nature and complexity. Should the future evolution of a financial institution result in a magnification of these aggravating factors, an additional reserve of 1% would be demanded from them.

What should we make of these measures?

There are three conceivable approaches when dealing with G-SIBs:

1) Dismantling them into small units the size of which is such that their default does not trigger any domino effect.
2) Discouraging or prohibiting those activities generating systemic risk.
3) Finally, trying to solve the qualitative through the quantitative: raising their reserves to a higher level than the pre-crisis one, hoping that the calculation was done correctly this time, with no guarantee that this is indeed the case.

In the Autumn of 2008, only the first two options were regarded as plausible, the third – which has just been chosen by the BIS – was dismissed due to its touching naivety. Turning their back away from learnt lessons, they come back to the out-dated risk management methods where nothing is done to control systemic risk and only potential losses are assessed.

Basel III makes no distinction between inescapable risk due to contingencies and risk voluntarily incurred. First among these, of course, wagers on price fluctuations – which were forbidden in France by article 421 of the French Penal Code until 1885, when it was repealed under pressure from the business world. Eliminating these wagers would greatly reduce overall risk and it would be possible to set the level of enforceable reserves much lower than it is now, limited to covering two risks: loan loss and any loss incurred due to the insurance-like activities of banks.

Because the legislator fails to force G-SIBs to be dismantled or reduce the systemic risk generated by their activities, Basel III has no choice but imposing – from 2016, and gradually until 2019 – a raise in their reserves.

The next crisis – should it be patient enough to wait until then – will necessarily be worse than the last one and such reserves will prove “to everyone’s dismay” to be insufficient.

Against those who are determined to bring doom upon themselves, even the gods remain helpless.