Basel III: The Path to A Debt Crisis

Have you heard of Basel III? If not, you are probably doing OK anyway. For now.

The problem is that we all need to start educating ourselves on it. The so-called Basel III regulations for international banking make it easy for governments to go into excessive debt without credit risk.

Back in 2013 the world’s leading governments got together to revamp banking credit-risk standards. The goal was to protect banks around the globe against another crisis like the one we now know as the Great Recession. Banks would become better at weighing risk and therefore steer clear of excessive exposure to bad debt.

This all sounds fine and dandy. There is just one caveat.

Today, the biggest problems with credit rating is not with the private sector. The free market has pretty much got that one covered. The problem is instead sovereign debt.

Governments borrowing exorbitant amounts of money.

You would think that when the world’s brightest minds get together to prevent another bank meltdown, they would take into account all forms of credit and all forms of risk that banks are faced with. But no: when the Basel III package of regulations was complete, government had been exempt from risk evaluation.

That’s right. When banks report their risk exposure to government regulators they are not supposed to grade sovereign debt based on risk. If a bank owns $1bn worth of Greek government debt and $1bn worth of Swiss government debt, it is supposed to weigh the two equally in terms of default risk.

The fact that the Greek government defaulted on 25 percent of its debt back in 2012 and keeps running deficits is supposed to be of no consequence.

It is not rocket science – or economics – to see what this means in practice. A government that borrows excessively to pay for its big welfare state does not have to worry about being downgraded. It can keep borrowing. At least in theory, it can even default on some of its debt without risking its credit rating.

Viewed from the other side of the table: a bank that has bought Greek debt and receives an offer from the Greek government to buy more, should have no reason to refuse that offer. While no government can force its banks to buy its debt, there are plenty of ways it can make the banks an offer they can’t refuse. The central bank, for example, can collude with the treasury by offering banks extremely cheap loans, hinting between the lines that if the money is used to buy treasuries, there is a lot more coming.

Then there is the fallout of the risk-assessment mechanics of Basel III. Regulations force banks to strike a “prudent” risk balance in their portfolios. To do so they will always need to hold sovereign debt. And here is where it gets interesting: since fiscally conservative governments do not borrow much but high-risk governments can dole out treasuries like free candy without risk (pun intended), the international banking system is simply forced to buy high-risk sovereign bonds in order to comply with risk-balance regulations.

All this is, of course, by design. The negotiators at the table in Basel came from assorted governments around the world, many of which are very generous to themselves in terms of going into debt. Those with the most serious debt addiction simply weren’t going to accept that they were called out for being fiscally irresponsible. Instead of taking responsibility for the long-term future of their countries, those governments pouted and threw political temper tantrums until they got a set of regulations that allows the children on the block to ride on the coattails of the adults.

We cannot underestimate the gravity of this outcome of Basel III. Long before the coronavirus artificial economic shutdown, governments around the world had made budget deficits a permanent form of paying for spending. Consider this table, courtesy of the latest IMF Fiscal Monitor:

Table 1: Government deficits as percent of current-price GDP

Source: IMF Fiscal Monitor

Some of the projections beyond 2020 are purely fantasmagorical. Sweden, for example, will not be able to balance its government finances without breaking the back of the country. (They are already hard at work doing just that.) Greece will slide deeper into debt as their economy continues to stall from heavy taxes. The German figures are irresponsibly optimistic, given that Germany is no longer the leading industrial investment magnet in Europe (that title is now shared between Hungary and Poland). Ireland is under a purely totalitarian economic shutdown and – like all totalitarian run countries – will not recover economically until the tyrannical rule has ended.

But even if we disregard these points and assume that the IMF is largely correct, the picture is chilling, not to say outright frightful. In 2025, 22 or the 35 jurisdictions listed will run deficits. Basically, the forecast is that by 2022 the world’s leading governments will be back to deficits as usual, as they were before the 2020 artificial economic shutdown.

This, again, is optimistic. It is more than likely that many governments will expand their welfare states in response to the economic crisis they themselves created. Since the shutdown has crippled private-sector activity – albeit temporarily – the tax base has been disrupted at the same time as governments are going to spend more money.

Since governments, thanks to Basel III, can borrow as much money as they want with impunity, our banking industry will increasingly become the source for funding of much of this government debt. Those banks, of course, need money to buy that debt.

Whose money? Ours.

But what if governments default on their debt? Don’t worry. Our governments have already taken care of that one. It’s called the Cyprus Bank Heist and means that if government defaults on debt owned by banks, then banks can simply confiscate our deposits to recover the money they lost to government. This was first done – legally – in Cyprus, hence the name. Since then, other governments have followed with legislation allowing their banks to do the same.

It remains to be seen just how bad the fallout will be from Basel III, but the policy message is clear: government will always take care of itself. If you won’t agree to fund it through confiscatory taxes, then government will always find another way to grab your money.