Thursday, January 3, 2013

Mamma Mia! The Basel II and III bank regulations are 180° wrong!


What is perceived as “risky” is never really risky in banking because by means of charging higher risk premiums (interest rates) allowing for smaller exposures and imposing stricter terms, the damages that result when “risky” turns out to be risky are usually small and very containable. 

Not so when what is perceived as “absolutely not risky” turns out to be very risky. In that case total mayhem results, and indeed all bank crises ever have resulted precisely from that. 

In this respect a bank regulator, if he knew what he was doing, could with some logic contemplate the idea of higher capital requirements for banks for assets perceived as “not risky” and somewhat lower for assets perceived as “risky”. 

But what a regulator could absolutely not do, if he knew what he was doing, was what they did in Basel II and are doing in Basel III, which is allowing for much lower capital requirements for assets perceived as “absolutely not risky”. In other words the regulators are 180° wrong. In other words they are making sure that the bank crises, whenever these occur, as a result of something ex ante considered to be “absolutely safe” turning out to be risky ex post, will be bigger than ever. 

Can this be true? Yes! Just try to ask a bank regulator the following question and you will see his eyes go foggy. “Dear Mr. Bank Regulator, can you explain to me what risks the current capital requirements are to cover for, and which have not previously been covered for in the interest rates, in the amounts of exposure and in the terms of the contract?” 

How could it be the regulators got it so wrong? It is a long story but the short version of it is that this sort of thing happens when you allow experts to toy around in the lab in a mutual admiration club without any adult supervision and not accountable to anyone. 

But it is even worse. Not only are Basel II and III regulations totally useless when it comes to stopping major crisis, they even stimulate those disasters to happen. By allowing banks to earn higher returns on equity when lending to “The Infallible” than when lending to “The Risky”, Basel II and III introduce distortions which makes it impossible for the banks to allocate economic resources with any degree of efficiency. 

But they say that Basel III is better? Yes much better, but only if you completely ignore what was wrong with Basel II. In reality Basel III, now also imposing liquidity requirements based on perceived risks; and knighting the too-big-to-fail-banks as Globally-Systemic-Important-Financial Institutions (which de facto classifies the rest as unimportant) will just make all much worse. 

Tax-payers, caveat emptor, our banks are regulated by experts gone crazy and berserk, and who think that if they just ignore my arguments their mistake will never have existed!