The Basel Accords & Mark to Market

Basel Capital Accords

The underlying basis of our modern-day banking system is based on fractional reserve banking. If a bank has say £1,000 in hard-cash, and if the fractional reserve ratio is 10%, this means the bank can create £10,000 of loans or credit or bank-account money out of thin air. This system of fractional reserve banking operated from 1694 up to the early 1980s but was abandoned because it was deemed to be to too restrictive, because the banks were forced to keep 10% cash to back up the 100% credit they created out of thin air.

Fractional reserve banking is clearly inherently unstable because if more than 10% of people want cash for their credit or bank-account money the bank will go bankrupt.

The Bank of England abandoned the 10 % fractional reserve ratio in the early 1980s because it was considered too restrictive for lending. Commercial banks in the major economies are now bound by the Basel Capital Accords, an international banking agreement that has determined how much money banks can legitimately lend since 1988. The central bankers’ central bank the BIS (Bank of International Settlements), based in Basle Switzerland, enacted Basel I in 1988.

The Basel Capital Accord I states that a bank’s lending is to be determined by a fixed ratio of its capital. The minimum capital ratio is 8%. This means that a bank with £8 billion in capital can lend or create out of thin air up to €100 billion. The £8 billion in capital does not have to be cash but can include government bonds and bank shares owned by the bank.

Fractional reserve banking stated that if the fractional reserve was 10% this meant that banks had to have 10% hard-cash for the 100% loans or credit they created. This was now reduced to 8% with Basel Accord I and the banks did not have to keep this 8% as hard-cash but could for example buy government bonds and earn interest on them, but still have the government bonds acting as part of their 8% capital reserves.

The Basel Capital Accords made our banking system even more unstable, with the liquidity or cash in the system reduced from an unstable 10% to a much lower rate.

Mortgage-backed securities

In the old days your local bank gave you a mortgage and you repaid the local bank. By the end of the 1980s commercial banks combined the individual loans they had made with homeowners, each loan underpinned by a legal agreement, and combined them together into a bundle of mortgages, becoming a “security” which could be traded.

These bundles of mortgages were attractive to investors because of the interest that the underlying loan agreements provided, and also the fact that the individual mortgages were legally underpinned, thus theoretically securing the capital. These bundle of mortgages are called mortgage-backed securities.

Banks started selling mortgage-backed securities to investors while servicing the mortgages themselves. In other words, the borrower would keep making his mortgage payments to the bank that made the loan, but the payment would be sent on to the investor who had purchased the mortgage-backed security from the bank. The investors were usually pension funds or large investment funds.

The banks made money by selling off a bundle of mortgages in the form of mortgage-backed securities. However by profitably getting rid of old bank loans off their balance sheet banks could now legally create more loans, more credit, by creating it out of thin air all over again. The securitisation of mortgages allowed banks to sell off old bank loans, and then legally permitted them to create new bank loans, which of course they did. Lending is almost costless anyway (because credit is created out of thin air) but it was now limitless! The bankers kept the party going by lending to anyone who could breathe. You have to admit it was beautiful! There was now no limit at all to the amount of credit bankers could create out of thin air. You now know why bankers, and in particular investment bankers make so much money.

Derivatives

Mortgage-backed securities are derivatives. Derivatives are what the billionaire investor Warren Buffet calls “financial weapons of mass destruction”.[i] Derivatives are so-called because they derive their value from an underlying asset. Derivatives mean that a security, whatever it is, such as a mortgaged-backed security, are backed by a real underlying asset, such as real mortgages, that have to be repaid by real people.

The Credit Crunch

During 2007, mortgage-backed securities were discovered to be toxic assets, because individual homeowners in the US had defaulted en masse on their real mortgages. When one particular bank did sell some of these securities, they were sold well below face value. Instantly, according to mark to market, this meant that the hundreds of billions of dollars of these securities, owned by banks world-wide, had to be marked down to market value.

Even if the vast majority of loans in the mortgage-backed security market were performing, with individual homeowners paying their mortgages, and even if the bank did not need to sell the securities for financial reasons, and could afford to hold onto them, all these other more solvent banks had to mark to market. The value of all their mortgage-backed securities had to be written down to market value.

When the value of these mortgage-backed securities were marked down to market value, this immediately reduced the capital of the bank, hence reducing the amount of loans they could make according to the Basel Capital Accords.

Mark to Market requires banks to adjust the value of their marketable securities (such as mortgage-backed securities) to market value. Mark to market meant that banks were not allowed to create new credit, and therefore the Credit Crunch occurred.

Quantitative Easing

Mark to market has meant that all this Quantitative Easing, high-powered money that has been inserted into commercial banks world-wide by central banks, has not resulted in them increasing their lending to small and medium sized enterprises and to real people. Instead this lending has contracted.  The big banks are just building up their reserves to comply with the accounting rules in the various Basel Capital Accords (1, 2 and 3).

As the real economy continues to falter because of a continuing declining money supply, bank losses will continue to rise. Combined with mark to market, these losses will have to be recognised in their balance sheets, pushing them further into insolvency.

Banks are not creating new credit because they are in effect recapitalising themselves in order to meet the Basel capital requirements. In the mean time the real economy is suffering a declining money supply and is in a death-spiral.

The Solution

The solution might be to abandon the Mark to Market accounting rule in Basel II. However this would be at most an interim solution. Mark to Market has exacerbated the fundamental problem with our banking system, which is that it is inherently unstable because the banks are legally allowed to create money out of thin air.

The real solution is for government to nationalise the creation of money (but not banking) for the public good.