My objection to “An Explanatory Note on the Basel II IRB Risk Weight Functions”, July 2005, Bank of International Settlements

The document referred to in the title describes how the Basel II risk-weights came about. I have two major concerns with what it states and one immense with what it ignores: 

First, it describe one important simplification needed in order to allow a practical implementation of a rating based capital allocation, namely that “The model should be portfolio invariant, i.e. the capital required for any given loan should only depend on the risk of that loan and must not depend on the portfolio it is added to…. . 

The simplification is justified with “A Risk-Factor Model Foundation for Ratings-Based Bank Capital Rules” by Michael B. Gordy a senior economist at the Board of Governors of the Federal Reserve System, October 22, 2002. 

And so it states “As a result the Revised Framework was calibrated to well diversified banks… If a bank failed at this, supervisors would have to take action under the supervisory review process” 

And that places an immense supervision burden on a body often not sufficiently equipped for it, and worse still, a body that had been sold a feeling that, with the rating based risk-weights, it had already solved the problem forever. 

Second it states: “Losses above expected levels are usually referred to as Unexpected Losses (UL) - institutions know they will occur now and then, but they cannot know in advance their timing or severity. Interest rates, including risk premia, charged on credit exposures may absorb some components of unexpected losses, but the market will not support prices sufficient to cover all unexpected losses. Capital is needed to cover the risks of such peak losses, and therefore it has a loss-absorbing function.” 

That is indeed correct, but that does not mean one can go ahead assuming that these risk premiums are covering zero of the unexpected losses, or that the market will “not support prices sufficient” the same over the whole range of perceived risks. In fact given basic bankers risk-aversion, I would make a case that where the markets do not support the prices correctly, is mostly for whatever is perceived as “absolutely safe”, and that, for the “risky”, it might overprice it instead.

Also if one must use credit rating information which is already available for the bankers to see, then instead of basing it on what the ratings indicate, one should base it on how bankers usually act when observing those ratings. Then they would have seen that bank crises never ever occur because of excessive exposures to "The Risky" but always from excessive exposures to "The Infallible".

Sincerely to use the expected as a proxy of the unexpected is as nutty as can be. The more safe an asset might seem the more room there is for bad unexpected events. The riskier an asset might seem the less the room for bad unexpected events.

And then finally, what the document completely ignores, is that the setting of differential risk-weights, by allowing banks to leverage risk and transaction cost adjusted margins immensely more for what is perceived as “absolutely safe”, introduces a very dangerous bias and distortion against what is considered as “risky”. 

And I just do not understand how that came to happen. Though banks do use risk-models to estimate appropriate capital levels, when looking for capital, they do not make separate share issues based on perceived risks, indeed, as all capital has usually to cover for all risks. 

In fact by allowing banks to hold much less capital against what is perceived as “safe” than against what is perceived as “risky”, regulators are in fact allowing for speculative profits, not on what is “risky” but on what is safe… and that turning the world upside down cannot be healthy. What about the efficient resource allocation function of our banks? With their risk weights the regulators are de facto telling us that those perceived as safe use bank credit more efficiently than those perceived as risky... and that we all know is not so.

And I must ask again: If banks are induced to make more profit on what is perceived as safe than on what is perceived as risky… then what is left for us… and for our orphans and widows?