Sunday, September 25, 2011

My proposal on capital requirements for banks

The Basel II bank regulations were built upon the pillar of a basic capital requirement of 8 percent, adjusted with risk-weights, based on the ex-ante perceived risk of default. Higher perceived risk, higher capital, and lower perceived risk lower capital. 

I have for years argued that this serves no useful purpose, and that it is outright dangerous because it stimulates the creation of excessive exposure to what is perceived as “not-risky” which is precisely what has caused and will cause all bank crises. Current Basel III proposal does nothing or very little to correct this fundamental fault. Here is what I propose. 

First of all, the capital requirement for all type of bank assets should be the same, for instance 8 percent, and this because the regulator has no role acting like a supreme risk manager for the world by arbitrarily assigning risk-weights, and which can only bring confusion to the market. 

But also if we want to try to have the banks fulfill their societal purpose, we could contemplate reducing somewhat those capital requirements, for instance up to 4 percent, when the banks engage in loans that for instance serve the creation of jobs or environmental sustainability. 

If we taxpayers are going to shoulder some of the risks of a bank failing, as we indeed must, then we should at least make certain that if a bank fails, it does so while trying to do something useful for us.

Of course we need a transition period in order to allow the banks to obtain all that capital they should have held, had it not been for the minuscule risk-weights assigned by the regulator. And, in order not to squeeze those perceived as “risky”, like the small businesses and entrepreneurs, more than they are being squeezed, we should, during this transition period, reduce the basic capital requirement, for instance to 5 percent, which allows for a leverage of 20 to 1. 

A temporary reduction in the basic capital requirement would clearly create some risk, but so does government stimulus financed with public debt, and I firmly believe it is preferably to have our banks take the lending decisions than government bureaucrats.