Capital Punishment: CORRECTED

We really wanted to like Basel III. Frankly, anything with a Roman numeral commands our immediate attention and respect: Super Bowl I, World War II, Rocky III.

Ok, maybe not Rocky III.

The name alone implies a certain tradition combined with a sense of progressive improvement. First there was Basel I (1988). Then came Basel II (2004). Now we have Basel III. Add the gravitas of a Swiss city and, well, we’re buyers.

But it’s a rough world we live in. All things once sacred are under scrutiny. Even as governments worked frantically over the past three years on a succession of plans to plug systemic cash leaks and bolster weak balance sheets, the unprecedented velocity of change in the financial sector made the best and brightest regulators look clueless.

Take Ireland. Please. Not four months ago that bedeviled country had passed European bank stress tests with flying colors, yet today it stands on the precipice of insolvency.

Then there are the new Basel III capital tests. Banks will have to comply with higher ratios to better withstand more drastic market downturns, yet the definition of the most important metric—risk-weighted assets—is left for the banks to determine themselves.

Closer to home, the Fed just released a report (detailed in a recent Deal article) on the risk profile of securitized assets. These findings at last distinguish between the best-in-class CLO vehicles, which never lost a dime of triple-A-rated investor capital, and the others, like sub-prime mortgages, which kick-started the credit crisis in the first place.

That’s good news for those who advocated such a distinction for years. It will hopefully provide ammunition that CLO managers shouldn’t be forced to retain 5% of each tranche – a Dodd-Frank requirement which threatens to put a damper on new CLO formation.

But the wheels of regulatory reform move ponderously relative to the speed of financial innovation. It could be well into next year by the time the FDIC and SEC weigh in on the Fed’s finding, marking over four years since the first signs of sub-prime trouble.

Loan securitization meanwhile has stumbled along, trying to regain investor confidence, while a riskier asset class—junk bonds—became the surer path to corporate liquidity.

Even if regulators instantly impacted markets they regulate, what about the markets they don’t? At $16 billion $16 trillion, so-called shadow banking assets—e.g. hedge funds, investment banks, and money market funds—dwarf those of “real” banks which hold $11 billion $13 trillion.

Finally there’s quantitative easing. We find it odd that QE2 is encouraging banks to lend at the same time Basel III discourages them from growing their risk-weighted assets.

If the almost $2 trillion in financial support that’s been pumped into the US system alone has so far failed to stimulate lending—cash seems to just be piling up on banks’ balance sheets —what’s the sense of another $600 billion?

Maybe they should have named it QE II.