Does BASEL Stand for "Banks Acting Silly to Enhance Liquidity?"

First, there was U.S. financial giant Bank of America (NYSE:BAC), telling the world it was selling off its chain of Pizza Huts to a private equity fund. A few weeks later, there was French bancassurer Société Générale (Paris:GLE), putting a "for-sale" sign on its fleet of lease-to-own aircraft. On Friday, it was British government-owned Royal Bank of Scotland (London:RBS), announcing it had sold off 918 pubs it had formerly operated to Dutch brewer Heineken N.V. (Amsterdam:HEIA).

Pizza restaurants, jet planes and bars are only the beginning of it.

As banks around the world race to satisfy international capital requirements, they are going through a veritable fire sale, getting rid of non-core businesses no matter how much they will fetch. Beyond that, they are engaging in some odd transactions, including a substantial amount of balance sheet engineering -- moving around certain holdings or re-arranging portfolios to favor certain assets, even if the total amount of equity does not change.

Blame it on the BASEL

The main reason: BASEL III, a set of internationally-agreed upon rules that dictate banks need to hold certain amounts of capital in their reserve as a buffer against future liquidity crunches. The rules, which are supposed to be phased in through a graduated six-year period beginning in early 2013, will require most banks around the world (but especially European banks) to save more for a rainy day.

Enforcing new global capital rules is a difficult task that can be easily construed as being arbitrary: something akin to race officials telling Formula 1 drivers in the middle of a race they will have to abide by a speed limit once the first driver begins his 47th lap. Because banks, like drivers, compete with each other, and holding a higher percentage of capital reserves hurts the bottom line, the expectation would be they would wait until the last possible second to abide by the new rules. Complicating the situation even more, while the Formula 1 drivers in the above example would not be able to get out of their cars to lobby, cajole or bribe race officials into delaying the adoption of the speed limit, bankers in the real world have no such limitations.

The results: as recently as September, Jamie Dimon, the iconic chief executive of JP Morgan Chase, was publicly railing against the adoption of the BASEL standards, labeling them "un-American." Many other bankers, while not publicly expressing the sentiment, were only very slowly raising capital.

That all seems to have changed in late October, when the deterioration of the sovereign debt crisis -- and specifically, decisions taken during the October 26 head-of-state summit -- indicated to the banks there would be no delay or exception in implementing the rules.

Indeed, the opposite has occurred. Sweden told its banks in early November it would be accelerating adoption of the BASEL capital requirement rules, something that was imitated by Austria on November 22. A day later, Canadian banking regulators were sending out a shot across the bow, noting that while they would enforce the new rules on the (relatively healthy) Canadian banking sector, the whole scheme might come undone if other countries were not as stringent.

While slightly more opaque than their global counterparts, American regulators, including John Walsh of the Office of the Comptroller of the Currency have said implementing the new capital requirements are a top concern, right up there with enforcing the new Dodd-Frank rules on financial regulations. And perhaps no one has gone as far as the British, where a central banker told banks on Wednesday they should look at withholding bonuses in order to shore up capital reserve.

"Optimizing" the books

Selling assets and holding back on pay are not the only ways banks can raise capital. Issuing new stock would seem like a natural solution, but the economy is soft and the returns on share issuance might be underwhelming. Another option: rebalancing, or "optimizing" the balance sheet.

The BASEL rules on capital don't treat all assets the same: certain assets the rules consider to be less risky, like AAA-rated government bonds, require much less of a capital buffer than, for example, commercial loans or credit derivatives.

As a result, most banks have been moving around their assets, selling the ones that require a larger capital buffer in order to acquire the ones that require little, if any reserves. The results have been some transactions that would seem bizarre in any other scenario.

Two of the largest Spanish banks, BBVA and Santander, have been shedding preferred stock from their books, forcing holders of those shares to exchange them for securities with shorter maturities, or common stock. While such actions can potentially affect the confidence investors will have in future bond issues from the bank, it seems they have been necessary in the era of BASEL. Lloyds, BNP Paribas and Société Générale have also engaged in similar exchanges, and a Société Générale analyst said Friday he saw Barclays, the Royal Bank of Scotland, Germany's Commerzbank and Italy's UniCredit as likely to follow.

There have also been actions to limit investment, as Austrian banks, for example, were told by their regulators last month to limit lending in central and Eastern Europe in order to conserve capital.

One of the strangest results of the banks' optimization has been the increase in the yield spread between bonds issued by two American mortgage loan insurers: Ginnie Mae and Fannie Mae. While both those entities execute the same functions (underwrite and insure mortgage loans) using essentially the same standards, and both have the backing of the U.S. government, Ginnie Mae bonds were paying a yield 300 basis points higher than Fannie Mae funds this year. The reason: banks were buying up Ginnie Mae securities, against which they do not need to hold a capital requirement, as per the BASEL rules, and selling Fannie Mae bonds (for which a capital reserve is required under BASEL).

And then it got really weird...

All this is happening even though the very first of the capital requirement rules haven't gone into effect yet. As the situation of the world banking sector improves or deteriorates in the next few years, as governments are formed and toppled, as liquidity crisis come and go, it is likely economic -- even geopolitical -- concerns will play into the ways banks decide to raise capital.

There is no end in sight to the surprises that are sure to come out of the trillions held in bank balance sheets.