Saturday, February 25, 2012

Bank regulators should learn about risk compensation and shared space philosophy.

Risk compensation, nothing to do with bonuses, is an effect whereby individual people may tend to adjust their behavior in response to perceived changes in risk. Individuals will behave less cautiously in situations where they feel "safer" or more protected. It is an argument that might help to explain the apparent paradox that reduced regulation leads to safer roads. 

The perceived risk of default in finance, functions like a natural traffic light. If the perceived risk for default of a borrower is high, the light red, banks lend less, at higher interest rates and on tougher terms. If the perceived risk for default of a borrower is low, the light green, banks lend more, at lower interest rates and on more lenient terms. 

The regulators though, with their capital requirements for banks based on perceived risks, by allowing for extraordinarily low capital requirements when the perceived risk were low, working like a collider, induced the banks to drive through the green lights much faster and with much lesser care, which resulted of course in this the mother of all financial pile-ups 

After a bank crisis characterized, as usual, by monstrously large exposures to what was officially considered as absolutely safe, like triple-A securities and infallible sovereigns, risk compensation is something our bank regulators should look into much more closely. 

According to the Shared-Space urban design philosophy, safety, congestion, economic vitality and other similar issues can be effectively tackled in streets and other public spaces by allowing traffic to be fully integrated with other human activity, not separated from it. Shared-Space streets have no traditional road markings, signs or traffic signals, and the distinction between "road" and "pavement" is blurred. The behavior of its users is more influenced and controlled by natural human interactions than by artificial regulation. 

Hans Monderman, 1945-2008, the Dutch traffic engineer known for his prominent role in the Shared-Space approach, was quoted saying: "We're losing our capacity for socially responsible behavior... The greater the number of prescriptions, the more people's sense of personal responsibility dwindles... When you don't exactly know who has right of way, you tend to seek eye contact with other road users... You automatically reduce your speed, you have contact with other people and you take greater care."

These days, when with their Basel III the regulators are digging our banks even deeper in the hole of excessive perceived safety, and we want and need our bankers to be better bankers and better citizens, we sure wish the Basel Committee would at least listen to some Shared-Space specialists.

PS. Risk-weighted capital requirements for banks, is also like allowing cars to go at different speeds depending on safety features, rated by "experts" and, of course, driven by fallible humans!!!