Johnny Åkerholm: Basel framework contributed to the crisis

It is noteworthy that the severest financial crisis happened just after the financial industry had implemented Basel II. The model puts the burden of risk assessment on the supervisors. There is neither room nor need for the old-time “prudent banker”, says Johnny Åkerholm, NIB President, in this interview with the NIB Newsletter.

A popular view of the financial crisis is that it was caused by greedy speculators, incompetent supervision and rating institutes, which gave too rosy a view of the risks. Do you support this opinion?

“I don’t think that imposing restrictions on the bonus systems and regulating the rating institutes would be enough to prevent future crises on the financial market. The fact is that the imbalance in financial markets was the consequence of too much global liquidity. There are some lessons that the central banks and regulators should draw from this situation.

The definition of inflation should be broadened. In the past, central banks were focused on consumer prices that were held back by the impact of globalisation. But they didn’t pay much attention to many other prices that were rising rapidly, including the non-traded service component in consumer prices. Low inflation figures let the central banks keep low interest rates, which gave rise to asset price increases and good returns on debt-financed investments. This added to risk-taking.

We are practically re-running the same situation these days: rates are low and the central banks are “printing money”, while virtually all prices, except the consumer prices in industrial countries, are increasing rapidly.

Macro-prudential surveillance must be improved. This will be challenging both in terms of analysis and communication. It is not easy or popular to convince investors not to be overly optimistic at the time of a bubble build-up, which in fact is happening now in many emerging economies.”

What are the major flaws in the current regulatory framework? Why did it not prevent the crisis?

“Basel II turned out to be a significant part of the problem. It is noteworthy that the severest financial crisis happened just after the financial industry had implemented the most expensive risk-averting framework ever.

The introduction of Basel II in the financial industry was supposed to align capital needs to risk-taking. Although the idea is clear and easy to accept, the model assumes that risks can be predicted by modelling the past. However, the further we look into the future, the more the structures change, and the less the past can tell us about the future.

Technically sophisticated models may make one believe that results with an accuracy of many decimals are actually the ultimate truth. Moreover, Basel II puts the main burden of assessing the risks on the supervisors, who accept the models. The supervised bankers, therefore, feel relieved believing that the risks are under control. There is neither room nor need for the old-time “prudent banker”.

Finally, and most importantly, the concept was based on a micro approach and did not add up at the macro level. The models tell us that in good times risks are small, as are capital needs. Hence, there is ample of room for aggressive lending, which leads to strong growth in the economy and seemingly less risks. In bad times, the modelled risks increase, and so do capital needs. In late 2008/early 2009, previously well capitalised financial institutions were rapidly running up against capital scarcity and had to hold their lending back. In doing so, the economy slows down, credit customers suffer, and risks are realised. A vicious circle is in place.”

Are the suggested changes to the Basel accord going to bring improvements to the regulatory framework?

“Further development of the Basel accord is, among other things, proposed to focus on the elimination of the cyclical problems by creating reserves in good times which can be used in bad times. This is to be realised by using an “objective” measure of the cycle. However, the fact is that there is no way to ex ante separate a cyclical variation from a structural change, and nobody is in a position to determine how wide and long the economic swings will be.

One should rather admit that this approach has reached its end. I believe solutions would lie in vesting more responsibility on the owners of the financial institutions.”

How do you interpret the fair value assessments to financial assets introduced by the International Accounting Standards Board (IASB)?

“This is another source of instability. Again, the basic idea is fine: financial institutions should report a “true” value of their assets and liabilities. In most cases, fair value assessments are based on the market value. In times of distress, market quotations disappear or become highly uncertain. But worse, when spreads go up and investors have to book losses, they also face increases in their own funding costs. As a result, the losses spread through the financial system in a negative spiral.

This happened in the autumn of 2007, and it is happening right now, as a result of the higher funding costs for many of the European governments. Do these registered losses by financial institutions give a “fair value” of their situation? This is so, only if they have to realise them, because they need the liquidity. Otherwise, this is a pure bookkeeping exercise which has, however, severe consequences for the real economy. This is also a micro approach which does not add up at the macro level.”