Capital adequacy rules known as "Basel II" become fully effective from April 2011, imposing much tougher requirements on banks to set aside capital against risks of default. The impact, the author says, will be severe.

I read the news today, oh boy. But it wasn’t about ten thousand holes in Blackburn, Lancashire. Rather it was about the latest populist attack on the banks. Now I’m not one of those who believe bankers do “God’s work,” but responsible lending is and always has been an engine of growth in the US. It is pretty hard to grow without being able to borrow. In fact, the politician’s cry for much of the last year has been, “Why aren’t the banks lending?”  The answer to this question is about to become, “Because changing regulations are making it difficult, if not impossible, for them to do so as they did before.”

Beginning in April 2010 and fully effective in April 2011, Basel II will require large banks, the principal targets of populist outrage, to set aside substantially more capital for non-investment grade lending than has been required for more than ten years. The aim is to offset the risk of different types of loans with the capital reserve required to back them. The change is not merely substantive; it is exponential. (As most readers will know, the rules are known as Basel rules as they are thrashed out by bankers regularly meeting in the Swiss town of that name.)

Here’s a simplified example of how the change will operate:

A bank decides to make a $100 million loan to John Smith against illiquid collateral, such as against his interest in a private company or investments in private equity partnerships. In general, such borrowers and such collateral are regarded as a BB credit (few if any individual borrowers are better credit quality than this, and in fact most are below this point.) If the loan had been made in 2008, the required reserve allocation of what is called the bank’s “Tier One” capital might have been $6 to $10 million, the same as it would have been had the bank been lending to an AAA credit such as IBM.

Under Basel II, however, the capital reserve allocation for the Smith loan will increase to between $50 and $80 million. As the internal cost of a loan is substantially made of up of the cost of the capital set aside to make the loan, this means that the cost for the bank on the Smith loan just increased by nearly 800 per cent. The IBM loan continues to be carried at the same, substantially lower capital allocation as it was pre Basel II. So who would you rather lend to, John Smith or IBM? In fact, even if John Smith were already a borrower, why would you continue to lend to him?  

The ramifications of Basel II go well beyond individuals and include leveraged buyout financing, trading of non-investment grade debt, financing of emerging companies and the like but that is not the subject of this article. Suffice it to say, the underlying issue is the change in required reserve allocation will make the internal cost of lending prohibitive for many types of loans to individuals as well as loans against a wide range of collateral.

So, it seems Congress cannot see what my dog would clearly howl over. It now wants to impose what many term a “tax” on large banks that will discourage risk-taking. Again, we would not argue that banks should make excessively risky loans. Sensible financings, however, are not limited to loans to AAA credits. I have a partner who made loans to BB clients for years and never lost a penny.

What the politicians fail to realise or are willfully ignorant of (it does seem that they have some issues with the regulators and financial regulations) is that Basel II already takes care of the issue by imposing stricter capital requirements rather than taxes or fees. The contemplated congressional legislation is not policy-based; it is more in the nature of punitive damages.

It used to be “let’s kill all the lawyers”, now it’s “let’s hang all the bankers”.  The world around the Washington DC Beltway is so scared of its constituents’ anger that the baby is about to be thrown out with the bath water. If this legislation passes solely to relieve the pressure on politicians caused by the anger of their electors, most lending to the wealthy individual, as we know it, will be all but over, be they wealthy entrepreneurs, asset rich investors, or small business. I wouldn’t call such a result responsive to constituents. I would call it the unforeseen consequence of another ill-conceived act.

So, when I read the news today, I say, “Washington, you must be kidding.”  The terrifying thing is - I know it’s not.