Of course, if the regulators wanted to calibrate adequately for the default risk of any bank exposure to any credit rating, they could only do so by taking into account how the banks would react to those credit ratings…as well as considering the banks’ relative exposure to the different credit ratings. If a bank lends only to triple-A rated clients then its systemic danger, is only represented by its triple-A rated clients.
Since perceived risk is cleared in the market through the interest rates charged, this has signified that the relative profitability for the banks of lending to what is perceived as not risky, like what has a triple-A rating, increased dramatically, while the relative profitability for the banks of lending to what is perceived as more risky, like unrated small business and entrepreneurs, decreased.
Knowing as we should know that no bank crisis has ever resulted from excessive lending to what is perceived risky and that they have all resulted from excessive investments to what is perceived ex-ante as not risky, applying the Basel Committee’s current regulatory paradigm of capital requirements based on risk results clearly in counterfactual and stupid regulations. Also, since the most important role of commercial banks is to help satisfy the financial needs of those who are perceived as more risky and have not yet access to the capital markets, the odious discrimination against these clients (who are already paying much higher interest rates into the capital of banks) is doubly stupid.
If by any chance the issue of regulating on climate change would fall in the lap of an entity like the Basel Committee… we would all be toast.
For over a decade, even as an Executive Director of the World Bank 2002-2004 and always under my own name and indicating my email, I have presented many arguments against the current central regulatory paradigm use by the Basel Committee, that of capital requirements based on perceived risk of default, and called it stupid, stupid, stupid!
And by the way, if the regulators absolutely have an existential need to calibrate for risks, what is so particularly risky with defaults? Is not the risk of not creating jobs or the risk of increased un-sustainability worse? Does not just to think of a world without defaults make you shiver?
Having said that, not once, in all these years, has anyone identified as having anything to do with the Basel Committee ever denied my accusations, presented any counter-argument, or shown the least willingness to discuss the issue. Is it not strange? Could it really be that little me is right and these so expert experts are so utterly wrong? I dare them to prove me wrong!
In October 2010, during the annual meetings of the International Monetary Fund I publicly asked “Right now, when a bank lends money to a small business or an entrepreneur it needs to put up 5 TIMES more capital than when lending to a triple-A rated clients. When is the IMF to speak out against such odious discrimination that affects development and job creation, for no good particular reason since bank and financial crisis have never occurred because of excessive investments or lending to clients perceived as risky?” Dominique Strauss-Kahn, IMF’s Managing Director, answered in no uncertain terms that “capital requirement discrimination has no reason to be”, and so it seems that there are also other who agree with that the Basel Committee stands there completely naked without a functional regulatory paradigm.
In this moment when an extremely serious financial crisis affects the world and when the Basel Committee is digging us even deeper in the hole they placed us in, would we all not feel more comfortable if the Basel Committee at least agreed to a public debate on what I criticize?
Therefore…members and professionals of the Basel Committee consider yourselves slapped on the face with a glove and dared to accept the challenge. Wear with dignity your cones of shame!
Want a more detailed explanation? Listen to this video
Ps. I appreciate any help I could get in provoking the Basel Committee to respond to this challenge
Ps. Is the Basel Committee another Nut Island type disaster?
Ps. US Congress, what are you up to? Over 2.000 pages of financial reform and you do not even mention once the Basel Committee which has so messed up the capital requirements of your banks.
Ps. A small numeric example: If banks were allowed to leverage only 12.5 to 1 when lending to triple-A rated clients, which is what they were allowed to leverage when lending to small businesses under Basel II, then if they made a .5% margin, they would obtain return on capital of 6.25% lending to AAAs, decent but nothing to write home about, less pay bonuses on. But since they were allowed to leverage 62.5 to 1 they could, with the same .5% margin then make a return of capital of 31.25%. No wonder banks stampeded after the AAAs!
Ps. A visitor from outer space, observing that banks are required to have 8% of equity when lending to a small businesses, but zero% when lending to a triple-A rated sovereign as the US, would he be at fault thinking he had landed on a communistic planet? With such an arbitrary discrimination in favor of the public sector, do you really know the real market interest rates on public debt?
Ps. Since I am no regulator, or a PhD with published research on the subject, hereafter follows some very few pieces of my curriculum against the Basel Committee, and that evidences I am just not another Monday morning quarterback:
November 1999 in an Op-Ed in the Daily Journal of Caracas I wrote “The possible Big Bang that scares me the most is the one that could happen the day those genius bank regulators in Basel, playing Gods, manage to introduce a systemic error in the financial system, which will cause the collapse, of the only remaining bank in the world”
March 2003 in a published letter to the Financial Times I wrote “Everyone knows that, sooner or later, the ratings issued by the credit agencies are just a new breed of systemic errors, about to be propagated at modern speeds”
October 2004 in a formal written statement delivered as an Executive Director of the World Bank I warned “We believe that much of the world’s financial markets are currently being dangerously overstretched through an exaggerated reliance on intrinsically weak financial models that are based on very short series of statistical evidence and very doubtful volatility assumptions”