The Credit Meltdown and the Shadow Banking System: What Basel III Missed

Saturday, September 25, 2010
By Paul Martin

Ellen Brown
HuffingtonPost.com
September 24, 2010

While local banks are held in check by the new banking czars in Basel, Wall Street’s “shadow banking system” has hardly been curbed by regulators at all; and it is here that the 2008 credit crisis was actually precipitated. The banking system’s credit machine is systemically flawed and needs a radical overhaul.

On September 13, the Bank for International Settlements issued heightened capital requirements that will make lending even more difficult for local banks, which do most of the consumer and small business lending today. The new rules are ostensibly designed to prevent a repeat of the 2008 credit collapse, but they fail to address its real cause, which involves a “shadow” banking system that has largely escaped regulation.

What went wrong in September 2008 was not that the existing Basel II capital requirements were too low but that banks found a way around the rules. The Basel II rules base a bank’s capital requirement on how risky its loan book is, and banks can make their books look less risky by buying unregulated “insurance contracts” known as credit default swaps (CDS). This insurance, however, proved to be what was effectively a fraud, when insurer AIG went bankrupt on September 15, 2008. The credit collapse that followed has normally been blamed on the collapse of the subprime housing market. But according to Yale economist Gary Gorton (whose views were recently embraced by Fed Chairman Ben Bernanke), the subprime problem was not itself sufficient to trigger a global credit freeze. What it did trigger was an old-fashioned bank run, in the not-so-familiar market known as the shadow banking system.

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