Impose the higher bank capital requirements on what has the best credit ratings

Published in Voxeu VOX CEPR

There can be no doubt that capital, in general, is risk-adverse, which creates considerable bias in favor of anything that is perceived as having a lower risk of default. In such circumstances the dangers of any systemic default lie much more in the realm of capital stampeding after investments that are erroneously perceived ex-ante as representing lower risk, than capital pursuing investments perceived ex-ante as having a higher risk of default.

In fact there has never ever been a major or systemic bank crisis that has resulted from the banks being involved with what ex-ante was perceived as risky; they have all resulted from lending and investing in what ex-ante was considered as not risky, given the returns offered. Even the Dutch tulips would, in their own bubble time, have earned them AAA ratings.

In view of the above the Basel regulations that lowers the capital requirements for what ex-ante is perceived by the credit rating agencies as having lower risks, and thereby increases the banks’ expected ex-ante returns from pursuing these “low risk” opportunities, seems sort of stupid to say the least.

We are now two years into a crisis that has resulted from many banks and lookalikes following some minuscule capital requirements when investing in securities collateralized with subprime mortgages and rated AAA. We are also in big trouble resulting from lending to well rated fancy sovereigns, like Greece, much because of similarly minuscule capital requirements.

Therefore what is most worrisome of it all is to see how our financial regulators simply do not yet get it, not even ex-post, and keep on insisting on their utterly faulted regulatory paradigm of risk-weighted assets.

What can we do to save the world from our financial regulators´ regulatory exuberance? Perhaps to shock them out of their lethargy asking them to invert the current capital requirements for banks, forcing any bank lending to a triple-A to require 8 percent of capital and allowing banks to lend to their natural clients the small businesses and entrepreneurs (who have never caused any crisis) with only 1.6 percent in capital.

Of course, I would much rather prefer regulators to totally refrain from meddling and discriminating based on risk; not only because of the previous argument, but also because risk is not confined to what we and regulators believe it to be, like clearly the AAA rated BP is reminding us of.