Charles Goodhart on “Culprit N° 1 : Basel II”
Charles Goodhart considers the underlying systemic problems behind the current financial difficulties.
The problem is not the availability of cash (liquidity in that sense). In order to keep market rates close to the policy rate, central banks have to inject whatever the banking system wants. Indeed Barclays has stated that it is “awash with cash”, as are probably most other commercial banks. Nor does it matter in which market the central bank operates; as long as the central bank wants short rates at a particular level, it must inject a given quantity of cash; whether by operations in the overnight, one-week, three-month or longer-term gilt market is a second-order issue. Of course, a central bank could target the three-month London interbank offered rate, rather than a one-week or overnight rate, but doing so now would be tantamount to a large cut in the existing policy rate.
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But in the longer term the underlying problem will become capital availability, not funding problems and certainly not cash liquidity. Worsening risk raises capital adequacy requirements, and lower profits and higher write-offs reduce the capital base. The Basel II framework for regulating banks’ risk capital will raise the sensitivity of capital adequacy ratios to risk. When it is introduced in Europe at the start of 2008, many banks will find their prior cushions of capital, above the required limit, eroding fast. That could extend and amplify the crisis.
Several of my colleagues at the financial markets group foresaw the dangerous pro-cyclicality of Basel II. Our foreboding may turn into reality sooner than we expected.
Capital, not liquidity, is the problem at the FT
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[...] Est Mater Studiorum, so here is Charles Goodhart a few weeks ago: But in the longer term the underlying problem will become capital availability, not [...]