Saturday, November 20, 2010

Asking about Propositum Bancos could help the Basel Committee break the Confundus spell.

Surely the Basel Committee must know by now that no matter how poorly defined their basic capital requirement for banks of 8% of the assets was in Basel II, this was not what caused many banks to hold insufficient capital. That was entirely the consequence of those so faulty risk-weights applied, those which for instance when investing in triple-A rated securities such as those collateralized with lousily awarded mortgages to the subprime sector, or lending to countries like Greece and Ireland, allowed banks to hold only 20% of the 8%, 1.6%, and therefore being able to leverage their capital 62.5 times to 1.

The basic mistake that caused Basel II to be so shamefully inappropriate was that the Basel Committee explicitly ignored the fact that perceived risk of default is already cleared for in the market by means of the risk premiums charged and so making a difference for it in the capital requirements accounts twice for the same risk. And that leads to making access for those perceived as less risky even easier and cheaper, creating the perfect storm conditions as bank crisis only occur because of excessive investments or lending to what is ex-ante perceived as not risky; and causes that those who already have difficulties accessing bank credit at a reasonable rate, like the small business and entrepreneurs, will find it even harder and more onerous to do so.

But the Basel Committee, instead of tackling the fundamental weakness of Basel II, the risk-weights, is in Basel III working on important but yet marginal issues. Clearly the lower but much stricter and cleared defined basic capital requirement of 7 percent announced is an improvement, but, its final effectiveness depends 100% on correcting the issue of the risk-weights... and which basically means throwing them out completely.

And that is why we get so nervous when according to re-“Calibrating regulatory minimum capital requirements and capital buffers: a top-down approach” October 2010 we read of how the Basel Committee tries to capture empirical knowledge by analyzing the “Return on Risk-Weighted Assets” completely ignoring that risk-weighted assets when weighted with their risk weights have no real meaning at all.

Clearly the Basel Committee has fallen under that spell identified by J.K. Rowling as “Confundus” (causes the victim to become confused, befuddled) and the first order of day must be to break it. How can it be achieved? First, we need to get rid of those regulators in the Basel Committee who are way beyond any salvage; and then we must awake the rest by asking the magical question “Propositum Bancos”… what is the purpose of the banks?

Of course too many banks should not fail by not being able to maintain sufficient capital to survive throughout a significant sector-wide downturn, but that is more of a minimum requirement, a restriction, and not at all a purpose. If we, after their huge failure, are to allow the Basel Committee on Banking Supervision to keep on regulating globally the banks, the least they should tell us is what they think the purpose of the banks is, and we should be able to agree on that.