Excuse me… what calibration?

During a recent conference titled “Financial Reform: What´s next” I had the opportunity to ask one of the Keynote speakers Mr. Donald Kohn the former Vice Chairman of the Federal Reserve the following:

Current bank regulations ordained by the Basel Committee require the banks to hold 8 percent in capital when lending to unrated small businesses and entrepreneurs while allowing the bank to invest in US government debt against zero capital. When looking at the interest rates in the market, how much do you think they are distorted by these discriminatory regulations?

His answer: “If the calibration is done right there are no distortions.” The session ended there and I had no chance to ask him: Sir, what calibration?

That which solely considers the risk of default, as perceived by the credit rating agencies, and that should at least consider the defaults of bank operations after the banks are given the credit rating information, and that should at least consider that those who are perceived as riskier pay higher risk premiums that goes into bank capital.

Why not a calibration based on different criteria, since the current calibration would sort of indicate that lending the funds to the government is infinitely more efficient for the society than lending them to small businesses and entrepreneurs… and that sounds not about right?

I am aghast at the thought that a financial super-expert can even think that if they are only well calibrated, the capital requirements for banks that discriminate among borrowers based on the risk of default as perceived by some few credit rating agencies, they will not distort… mostly because that can only mean the regulators will now proceed to dig us even deeper in the hole they placed us in.