Banking with Basel

Or, how banking regulations drove the world economy over the cliff. The Basel agreements on international requirements for banking capitol drove banks into unsound lending.
To understand the issue, we have to understand "capital" as related to a bank. Let's try a simple case, a medieval bank that gets its funds from depositors, in gold, and makes loans. Obviously such a bank cannot loan out ALL the money in the vault, they have to hold onto some money to cover withdrawals and losses (some borrower fails to repay his loan). Obviously the amount of capital to keep is a delicate balance. Money sitting in the bank's vault pays no interest, so the banker is motivated to loan it all out. On the other hand, the banker knows that he can't go THAT far, if he does he will be unable to pay off a depositor, and then a lot of bad things happen, like a run on his bank, tar and feathers ...
Now a days things are more complex, but the issue of capital reserves is the same. Banks ought to keep adequate capitol reserves to cover bad loans. But, now "capital" is more than gold coin. We count paper money, US treasury bonds, and less safe things like mortgages, Greek bonds, common stocks, anything that could be quickly sold for cash to meet obligations. Things like real estate don't count as capital because they cannot be sold quickly. Suppose you needed to sell the Empire State building to raise cash; how long would it take to find a buyer? Who knows.
To create a level international banking field, the big boys got together at Basel Switzerland and set up rules for how much capital banks must hold, and what things count as capital. They even talked the American SEC into imposing these rules on US banks. Trouble is, the Basel rules are bad rules. And every bank got pushed into doing things the Basel way. Under Basel , banks had to hold 8% capital against corporate loans, 4% against mortgages, and 1.6% against mortgage backed securities.
Right there you can see we are in trouble. Everybody knows that mortgages are pretty sound investments ("Safe as houses" they used to say), but mortgage backed securities are extremely risky. But the Basel rules encourage investment in flaky mortgage backed securities instead of genuine mortgages.
It gets worse. Basel defines sovereign debt (Greek bonds) as risk free, so a bank can buy any amount of sovereign debt (loan to flaky Euro governments) and not have to hold any capital at all. This was pure crazy. What is sounder, bonds issued by the likes of IBM, Southwest Airlines, Caterpillar Tractor, or bonds issued by Greece, Iceland, Ireland, or Albania? What kind of loan does more to develop an economy? Loans to flaky governments to pay for welfare benefits, or loans to productive corporations that create jobs?
Basel "regulation" is responsible for the Euro debt crisis. It encouraged banks to load up on high paying but flaky bonds, and now the flaky is coming home to roost (default) Plus, no longer do bad things happen to bankers who make dangerous loans. TARP or the ECB or somebody bails out the loser banks and nobody looses their job or gets prosecuted.
Regulation can be a disaster.