Saturday, April 16, 2011

Fraulein Basel’s Chocolate Cake

There was once a family where mother father, elder brothers and sisters and, of course, the grandparents, all lovingly cared for the well-being of the youngest family member, little Bob. For instance, they always informed little Bob about the risks they perceived existed in park AAA when compared to those present in the riskier park BBB. But, that said, they were also very careful of not producing any undue temerity in little Bob, since, besides wanting him to grow up and become a daring man, and not remain a frightened boy, they also knew he needed to go and play in park BBB, quite often, because there was where he could get the exercise that could make him strong. All in all, little Bob was growing up nicely.

Unfortunately, one day the family hired a governess to watch out over young Bob, Fraulein Basel. She, scared stiff she would be blamed for anything bad that could happen to little Bob, promised him a whole chocolate cake every day, if he would only go and play in the super-safe park AAA. Little Bob, as any healthy young boy, was naturally thrilled with the idea, and thereafter visited only park AAA. But, after eating a whole cake every day, one day in park AAA, suddenly, out of the blue, an  extremely slow but yet venomous snake appeared, and little obese Bob could not run away, and so little Bob tragically died.

And that my friend is what happened to our banks when we placed them in the overly caring nervous hands of Fraulein Basel Committee. 

But now, more than three years into a crisis that has caused so much misery around the world, we have yet to hear the World Bank and the IMF or anyone else for that matter commenting on the role of Fraulein Basel’s stupid chocolate cake. 

And our banks are still in Fraulein Basel hands even though we know she has not abandoned the stupid idea of the chocolate cake, and thinks it is only a matter of a better chocolate cake, Basel III; which she will soon present to another little Bob… or Hans… or Pedro… since her reach is global.

Translation: The mother of all regulatory mistakes

The Basel Committee even though they knew that banks were already considering the information on risks of default when they calculated the risk premiums and set the interest rates, decided to use that same risk information to set their capital requirements. Of course, considering the same risk information twice, exposed the bank more than ever to the very real possibility of that risk information not being perfect.

That stupid and unforgivable mistake resulted in: 

1. The setting of minimalist capital requirements that served as growth hormones for the ‘too-big-to-fail’. 

2. That banks overcrowded and drowned themselves in shallow waters, whether of triple-A rated securities backed with lousily awarded mortgages to the subprime sector, or of equally or slightly less well rated “infallible” sovereigns, like Greece. 

3. A serious shrinkage of all bank lending to small businesses and entrepreneurs, as lending to these generated, in relative terms, much higher capital requirement, which made it difficult for them to deliver a competitive return on bank equity.

And the dumb regulators have still not understood, that you do not regulate banks based on perceived risks, but based on what banks might do with perceived risks.