Tower of Basel: The Shadowy History of the Secret Bank That Runs the World (37 page)

BIS officials were especially concerned about the Federal National Mortgage Association (FNMA), known colloquially as Fannie Mae, and the Federal Home Loan Mortgage Corporation (FHLMC), known as Freddie Mac. The two institutions were government enterprises that provided liquidity to the mortgage system. They purchased home loans, providing the loans met their criteria, and turned them into mortgage-backed securities. Freddie and
Fannie then sold the securities to outside investors and guaranteed both the principal and the interest payments. Thanks to the government’s imprimatur, the system worked and remained stable.

But in the early 2000s, Wall Street worked out how to purchase and securitize mortgages without going through Freddie or Fannie. Finance houses such as Lehman Brothers and Bear Stearns bundled high-risk subprime mortgages—those granted to borrowers with a poor credit rating—into securities. The Wall Street finance houses then sold them to investors, few of whom understood the risks they were buying.

The global credit system was vastly overstretched. The BIS had repeatedly warned that excessive global credit growth, poor lending practices by commercial banks, private sector excesses and global imbalances were fueling a potential crisis. But as rivers of easy money flowed around the world, it seemed nobody was listening. BIS officials did not consider Freddie and Fannie to be a contaminant of global markets. Rather, they were a potential trigger for disaster. The central bankers needed to take notice. The place to discuss Freddie and Fannie was the BIS Committee on the Global Financial System. The committee, composed of deputy governors of central banks and other officials, was charged with analyzing and responding to stress in global financial markets. But it seemed that the central bankers did not want to talk about Freddie and Fannie. The issue was considered politically untouchable.

The United States was not the only country with powerful and risky government-sponsored enterprises—commercial companies backed by the state. France had its Caisse des dépôts et consignations, a state development and investment fund; each German state had its own bank, known as a Landesbank, and Japan offered banking services at its post office. The combination of state guarantees for commercial risks was potentially explosive, whether in Tokyo, Toulouse, or Texas. Attempts were made to get the committee to consider the whole question of government-sponsored enterprises, without focusing attention on any one country. These too, failed.

Long after he left the Bank of England, the BIS annual reports remained essential reading, said Rupert Pennant-Rea.

                 
The BIS started warning about the problems with excessive credit growth, excessive interconnectedness and some of the other major frailties in the financial system back in 2003 or 2004. Everybody says nobody foresaw 2007–2008; that’s not true. One organisation that did was the BIS. Not in every detail. But in terms of warning, that things were going wrong, that there was far too much debt on every sector’s balance sheets, that banks were in a very dangerous interconnected area, with positions against each other and overleveraged, a lot of that is in those rather dull looking annual reports.
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The work of hosting the BIS committees is less glamorous than, for example, preparing for the governors’ meetings. But in the long-term the committees are at least as useful for the bank: the BIS has made itself a central, indispensable pillar of the forums dealing with the most important questions about the global financial system. Every year more than five thousand senior executives and officials from central banks and supervisory authorities travel to Basel. The bank organizes specialist gatherings on topics including monetary and financial stability, reserve management, information technology, and internal auditing. Over the years the BIS has made itself the central hub for the world’s central bank governors and their staffs.

Among the bank’s six committees, only the Basel Committee on Banking Supervision that deals with commercial banking supervision, usually receives media attention, as its work directly affects the public that hold their accounts in commercial banks. The aim of the Basel Committee, as it is usually known, according to the BIS website, is to “enhance understanding of key supervisory issues and improve the quality of banking supervision worldwide.”

PARADOXICALLY, THE INCREASE
in globalization was highlighting national banking disparities. Not only banking supervision standards varied from
country to country, but so did the definitions of capital assets. Some banks counted long-term debts and off-balance sheet items as assets, while others did not. In 1988 the Basel Committee drew up new rules, which said, in essence, that bank capital must equal at least 8 percent of its assets, including its loans and liabilities. If a bank did not have sufficient capital, it must reduce its liabilities and risk exposure. The committee has no powers of enforcement, but it does have enormous moral authority. Any bank wishing to operate on international markets must adhere to the 8 percent rule.

Basel I, as the 1998 accord is known, has continued to evolve. Basel II, published in 2004, further honed and regulated capital requirements, quantified risk, and standardized international regulations, so as not to create competitive inequality, meaning that customers search for banks with looser controls. Regulating capital requirements while leaving banks free to lend is a delicate balancing act, said William McDonough, who served as chairman of the New York Federal Reserve from 1993 to 2003, and chaired the Basel Committee from 2000 to 2003. “One recognizes that there is an inherent conflict. The avoidance of financial crises is the public good, so for that a higher capital requirement is better. On the other hand, the whole capitalist free market system works by the savings of some being transferred and made available for the investment of others. So there has to be a trade where one does the best one can.”
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Looking back with hindsight at the economic crash of late 2007, it is clear that the capital requirements of Basel II were insufficient, said McDonough. “The aim of Basel II was to bring up capital requirements but to do so in a way that would not stifle the world economy. In the event the rules were not as strong or as fine-tuned as they needed to be when the crisis came.”
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The Basel III accords, which have not yet been implemented, aim to further hone the regulations governing banks’ capital requirements.

No matter how dedicated the regulators are, they are always behind the traders. McDonough said, “We did not anticipate the blowing up of the exotic instruments that brought down Lehman Brothers and the spin effect that resulted from that. If it had been, then hopefully somebody would have tried to avoid
it.”
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But the regulators, like generals, are inevitably fighting the last battle. Capital moves faster, the global economy is ever more entwined, and financial instruments are more complex. Each time a new set of rules is issued, Wall Street hires the best and brightest financial and legal brains to find a way to push compliance to new limits. Despite its legions of experts, the BIS was unable to predict or prevent the Libor scandal, when commercial banks made vast profits by manipulating interbank lending rates for their own advantage. The Basel banking accords did not deal with Libor.

For all its endorsement of good bank governance, the BIS has been criticized over its own commercial actions. The BIS’s main shareholders have always been central banks, but after the bank was founded in 1930 some of the original shareholders—US, French, and Belgian banks—sold part of their holdings. At the end of 2000, almost 14 percent of the BIS’s capital, 72,648 shares, was still in private hands and being traded. The BIS announced that it would buy back those shares in a compulsory re-purchase. Thanks to the BIS’s legal status, the decision could not be contested. But the price could. The bank offered 16,000 Swiss francs per share.

Three shareholders refused to accept the price. It was around twice the shares’ trading price but still less than the shares would be worth if valued as a proportion of the net asset value of the bank, they argued. First Eagle Funds, a New York–based group of mutual funds, and the other two, small private investors, took the case to the Hague Arbitral Tribunal, which governs disputes with the BIS. The tribunal ruled in their favor. It said that the BIS had miscalculated the shares’ value. The tribunal awarded the private shareholders an extra 7,977.56 Swiss francs per share, plus 5 percent interest, bringing the total extra to 9,052.90 Swiss francs—over 50 percent more than the original offer.
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The decision, noted the
Central Banking Journal
, was a “humiliating rebuff” for the board of directors who had signed off on the original price, including Jean-Claude Trichet, chairman of the Federal Reserve Alan Greenspan, and the governor of the Bank of England Sir Eddie George.
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The problem was not the compulsory squeeze out of private shareholders, said Charles de Vaulx, then the portfolio manager of First Eagle Funds, and now chief investment officer and portfolio manager at International Value Advisers. “I could understand that it was an accident of history that the shares happened to be listed, and the bank wanted to buy them back. But the price has to be fair. A squeeze-out deal, which is compulsory, has to have higher standards. The supreme irony is that the BIS has always portrayed itself as promoting proper capital adequacy, transparency, corporate governance, all these good things, which make the world a better place. But when it came to buying back their own shares, why aren’t they holding themselves up to the same standards?”
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Andrew Crockett, the BIS’s general manager from 1994 to 2003, said at the time that he believed the offer was “fair” based on the valuation by J. P. Morgan.
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MEANWHILE, IN FRANKFURT,
the European Central Bank flourished. The ECB is now one of the world’s most powerful central banks. It manages monetary policy for seventeen Eurozone members, an area that reaches from the Atlantic coast of Portugal to the Turkish frontier, and which is home to more than 330 million people.

The influence of the BIS, the ECB’s parent bank, is clear. The ECB is an ultramodern, even a postmodern institution—as Paul Volcker noted—a central bank without a country or national reserves. It is the ultimate financial expression of Jean Monnet’s supranational dream. But the ECB’s founding ethos is firmly rooted in the Norman-Schacht era. Its structure, modus operandi, and lack of accountability mirror that of the BIS. Like the BIS, the ECB is rigorously protected by international law, in its case the Maastricht Treaty that founded the European Union.

This is partly because the ECB was always a political as much as a monetary construct, rooted in trade-offs and behind-the-scenes deals. As the most powerful central bank in Europe, the Bundesbank was extremely influential in the design of the ECB. The Bundesbank ensured that the ECB’s “primary objective,” as the ECB notes on its website, is to “maintain price stability” with inflation rates below 2 percent.
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(The Federal Reserve, in contrast, has a dual mandate of combating
unemployment and inflation.) “The Germans take a very narrow view of the proper role of central banks, that it is to do almost exclusively with the preservation of price stability,” said William White. “That comes from their history and experience of hyperinflation.”
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To whom then is the ECB democratically accountable? In effect, nobody. The ECB’s Governing Council has direct control over the tools of monetary policy. It is prohibited from taking advice from Eurozone governments.
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The European Parliament has no meaningful authority over the ECB. “The ECB enjoys an extraordinary amount of independence,” wrote Professor Anne Sibert, an expert on bank governance, in a 2009 paper. “It has an unusual amount of target independence; its degree of operational independence is probably unprecedented; it is almost completely financially independent; it is nearly functionally independent,” meaning that the ECB has control over most instruments of monetary policy and the freedom to use them as it sees fit.
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The ECB does issue a press release after the monetary policy meetings of the Governing Council, detailing any changes in bank rates and the ECB’s president holds a press conference. The bank also publishes a monthly bulletin. But this is the bare minimum of reporting requirements – and a long way from proper accountability. Like the BIS, the ECB keeps its inner workings secret. “The ECB lacks transparency, especially procedural transparency,” noted Professor Sibert. “We do not know how decisions are reached; it appears that votes are not even taken. Press conferences are no substitute for a failure to publish minutes.”
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The US Federal Reserve issues a press release after each meeting of the Federal Open Market Committee (FOMC). The release includes the vote of the FOMC and the views of any dissenters. After each meeting of the FOMC, the minutes of the previous meeting are released, with a detailed summary of the reasons for the policy decisions taken. The Federal Reserve is accountable to Congress. The bank’s chairman appears twice a year before Congress, and before each appearance the board submits a comprehensive report. It is a meaningful, comprehensive analysis, taking in the interconnections between monetary and fiscal policy and the impact of the Federal Reserve’s decisions. The
Bank of England also publishes the minutes of its monetary policy meetings, with a two-week delay.

The European Parliament has passed repeated resolutions demanding that the ECB publish the minutes of the Governing Council meetings and to release a summary of the vote, without naming names. The central bank governors who are members of the ECB’s governing Council use the same arguments as to why this should not happen as those advanced by BIS officials for not releasing any minutes of the governors’ meetings: that they would limit the free exchange of ideas at the meeting. The minutes of the ECB Governing Council might also reveal, how despite the ECB’s claim to be above national politics, the governors of member central banks can still put their home countries’ interests before those of the Eurozone as a whole.