All the Devils Are Here [39]
Nor, of course, are bank portfolios always sound. The history of banking is filled with episodes of mania, going back at least to the South Sea Bubble in the 1720s, when bankers lost their heads and made foolish loans. In such instances, when a raft of bad loans couldn’t be paid back, banks were suddenly shuttered and a financial crisis often ensued, requiring government intervention.
To protect against defaults, banks hold capital in reserve, which can be used to fill the hole in the balance sheet if loans go bad. In the late nineteenth century, the U.S. government forced banks to hold a staggering 30 percent of their capital in reserve. That onerous requirement eventually disappeared, but in the wake of the Latin American debt crisis of the 1970s—a crisis that nearly brought Citibank to its knees—federally mandated capital requirements made a comeback. U.S. banks were required by the Federal Reserve to set aside enough capital to cover 8 percent of their assets. In the view of the government, mandatory capital was a critical safety net. (As Alan Greenspan himself later wrote, “Adequate capital eliminates the need for an unachievable specificity in regulatory fine tuning.”)
Around the same time, the idea of creating global capital requirements began to gain currency. The rationale was that in an increasingly globalized marketplace, it was important for all the big international banks to play by the same rules, so that one country’s banks wouldn’t have an advantage over another’s. The group that was formed to put together these international rules was the Basel Committee on Banking Supervision, which began its work in 1974. By the time the Basel Committee proposed, finalized, and implemented its new capital rules, called Basel I, some eighteen years had passed.
Why did it take so long? Partly it was because international bureaucracies always take an absurd amount of time to get anything done. Partly it was because, during those eighteen years, banking was becoming increasingly complex and the proposed capital rules were constantly trying to catch up to that complexity. And partly—perhaps most important—it was because, throughout the process, the banks fought to both weaken the capital rules and turn them to their advantage.
Banks, you see, hate having to hold a lot of capital. Though they understand the importance of capital rules, they also know that every dollar of capital held in reserve is a dollar that can’t be used to make a loan. So there has always been a struggle between regulators trying to impose capital requirements and banks trying to minimize them.
Prior to Basel I, every asset on a bank’s books, no matter how risky, required the same amount of capital. Yet as banks broadened into derivatives and other areas that went well beyond commercial lending, it became increasingly clear that different assets had different risks. That’s the complex reality the Basel Committee was trying to reflect.
Basel’s solution was to adopt what it called risk-based capital requirements. That is, the amount a bank had to put aside in capital would depend on the riskiness of the asset. Commercial loans were in the riskiest bucket, requiring the full capital ratio. But mortgages were viewed as less risky, presumably because people would go to great lengths to avoid defaulting on their home, so they required less capital than a commercial loan. With some prodding from the banking industry, the Basel Committee agreed that private-label mortgage-backed securities—that is, mortgage bonds not backed by Fannie or Freddie—should have a risk weighting of 50 percent of the riskiest weightings, such as commercial loans. Mortgage-backed securities insured by Fannie Mae or Freddie Mac were viewed as the safest of all, since those loans were backed (implicitly)