Wednesday, September 15, 2010

The recent pronouncements from Basel III are the latest regulatory attempt to play the role of Atlas beneath the world economy. Certainly, increases in primary capital ratios, specifically common stock paying no dividends, provide an increase in the margin for error. However, a ten year period to actually achieve those ratios eliminates the hope these regulations will mitigate systemic risk for the next decade. More central to the question of regulation is not ratio management, but the taking of risk by the banks. Critical problems at the banks were inventory levels of and exposure to securitization products, proprietary trading operations and the banks’ counterparty risks. None of these three areas were addressed by Basel, rendering it a hollow attempt to actually reduce systemic risk in the international banking system. Unlike Lady Gaga, Basel needs to be meatier to be effective.

The vast underfunding of municipal pensions has recently begun to see the light of day in the financial press. Simultaneously, corporate pensions, which have been predominantly fully funded, are now falling behind actuarial targets due to the Sharia compliant yields of U.S. treasuries and credit worthy corporate bonds. What are the potential implications of these trends for private equity? One possibility is increased allocations to PE on the mistaken belief higher PE returns will appear asynchronous with low financial returns in more liquid markets. A more daunting harbinger is the Harrisburg, PA situation as contractual defaults become a choice for liquidity-strapped municipal pension funds facing capital calls. More likely an eventual renegotiation of the benefit liability will have to occur, but it will be coupled with more conservative investments, not PE, to ensure payment. The recent unilateral reductions of benefits for existing retirees by the State of Minnesota is the test case for the next decade.

Although the rules have not yet been written, the Dodd-Frank Act has set forth new compliance requirements unlikely to add to the sum total of human knowledge, but likely to cost a great deal of money to fulfill. The Dodd-Frank Act is akin to the 1933 National Recovery Administration, set up to stabilize business with codes of “fair” practices, but later declared unconstitutional. In this case, since PE is already regulated by the 1933 and 1940 Securities Acts, we hope it is declared unnecessary.

I’m Rob Morris and I approved this blog.

Is Basel Faulty?