Two cheers for Basel banking rules

HAD the financial system held more capital two years ago, the world today would look very different. Most big firms would have coped; there may even have been no bailouts. It had become the received wisdom among regulators, firms and academics – all users of fancy models – that banks could operate on razor thin-reserves; how wrong they were.

So the “Basel III” reforms make sense, in part at least. Banks will have to hold high-quality capital -- “core Tier 1 capital,” equity or retained earnings -- equivalent to 7 per cent of risk-bearing assets. Banks will have five to nine years to implement this. They will also have to take greater account and put cash aside against credit exposures, which is good.

Liquidity rules are being introduced – though it remains to be seen whether holding government bonds and “high quality” corporates is a panacea in an era of faulty credit ratings and sovereign crises. And one proposal floated yesterday makes no sense: the idea that an extra 2.5 per cent would have to be put aside at the height of a boom to help counter the cycle – the twenty or so countries signing up to Basel will never be able to agree when to act. And what if everybody gets it wrong together? More work is still needed.

ON EGGS AND BASKETS
SHAKESPEARE, the Talmud, the Bible and modern mathematical financial theory have one thing in common: they all advocate the benefits of diversification. The Merchant of Venice put it best in 1596:

My ventures are not in one bottom trusted, Nor to one place; nor is my whole estate
Upon the fortune of this present year: Therefore, my merchandise makes me not sad.

Not putting all of one’s eggs in one basket is the central tenet of prudent financial management – it inspired strategies pursued successfully in recent years by hedge funds and other investors, as well as many of the analytical models used to gauge risk.

The trouble is that diversification only works if assets perform differently: for example, if UK housing does badly when Asian stocks do well or if gold tends to rise in value when the FTSE goes down. But when everything starts to move in lock-step – and all assets fall and rise at the same time – then we are in trouble. Returns collapse and panic sets in – remember, at the height of the credit crunch, when even cash in bank accounts suddenly seemed extremely risky?

Correlations between asset classes are on a long term upward trend which reflects the internationalisation of financial markets and improvements in information technology, an excellent analysis from HSBC’s foreign exchange team confirms. There is little chance that correlations will fall back to the levels of the mid-2000s. Correlations tend to go up during crises – and they really shot up this time around – and tend to go down when growth is stronger, but the trend is nevertheless upwards.

In the past, high correlations were associated with intense volatility; but correlations have stayed high in recent months despite lower volatility.

Eventually, when economies recover, different countries will begin to pursue different policies at different times and assets will no longer be as correlated as they have been over the past couple of years. There will be no going back to the good old days, however – we are all going to have adjust to the more limited power of diversification.

allister.heath@cityam.com

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