Are Basel capital rules the biggest regulatory failure in history?

By Leith van Onselen

Yesterday, while reading’s Top 10, I came across an interesting article published last month in The Economist, which explained how for decades banks in developed nations have been boosting mortgage lending at the expense of businesses, hurting entrepreneurship and productivity in the process:

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… the traditional view that banks primarily lend to businesses is out of date. In 1900 only 30% of bank lending was to buy residential property; now that figure is around 60% (see chart). Since the 1970s virtually the entire increase in the ratio of private-sector debt to GDP around the world has been caused by rising levels of mortgage lending. Corporate borrowing has remained flat. Far from channelling money to companies, modern banks resemble “real-estate funds”… in which long-term mortgage lending is funded by short-term borrowing from the public.

…the growth of mortgage lending has led to property bubbles and financial instability…

If mortgage lending is so risky, why are bankers so keen on it?.

…changes to international regulations on bank capital since the 1970s have… increased the supply of mortgages. Under the Basel I rules, which were first adopted in 1988, mortgages were deemed to be half as risky as corporate loans; some national regulators adopted even more skewed risk-weightings…

Subsidies and regulations that encourage mortgage lending, in short, have the unintended consequence of stemming the flow of capital to small firms, thereby holding back the economy as a whole.

The findings certainly accord with Australia’s experience, whereby the share of total lending to housing has more than doubled since the early-1990s, at the same time as the share of corporate loans has nearly halved (see next chart).

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The financial sector’s share of the economy has also doubled since financial markets were deregulated in the mid-1980s (see next chart).

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And mortgage debt, along with real house prices, have grown rapidly to all-time highs (see below charts).

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The skewing of bank capital rules is shown clearly in the below table illustrating the risk-weightings applying to mortgages under APRA’s Standardised Approach to managing credit risk, which is based on the Basel II Capital Adequacy Accord:

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Whereas most lending to corporate borrowers is ascribed a 100% risk-weighting (i.e. an 8% capital charge), most residential mortgage lending is ascribed a risk-weight of just 35% (i.e. a 2.8% capital charge).

The situation is even worse for the Big Four banks and Macquarie, which fall under APRA’s Advanced Internal Ratings-Based (IRB) approach, and therefore use their own internal models to calculate their capital held against mortgages. Under these IRB models, the Big Four’s capital charge on their total residential mortgage books range from only around 15% to 23%, with the average capital charge against mortgages a meager 1.2% to 1.9% (see below charts).

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Given the massive bias against productive businesses, and the record high level of mortgage debt and house prices, one has to ask: are the Basel bank capital rules one of the biggest regulatory failures in history?

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Unconventional Economist

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