Thursday, March 21, 2013

Dear finance professors of the world, can you please help me?

Before the Basel Committee regulations’ era, banks cleared for (ex-ante) perceived risk, that information which for instance is to be found in credit ratings, by means of interest rate (risk-premiums), the size of the exposure, and other contractual terms; let us call that “in the numerator”. 

But Basel II, and now Basel III, instruct the banks to also clear, I would call it re-clear, for exactly the same (ex-ante risk) perceived risk, credit ratings, “in the denominator”, by means of different capital requirements, more risk more capital, less risk less capital. 

That is just plain crazy. Allowing banks to leverage many times more when lending to what is perceived as “safe” than when lending to what is perceived as “risky”, allows the banks a much higher expected risk-adjusted return on equity when lending to “The Infallible” than when lending to “The Risky”. That distorts and makes it impossible for banks to allocate resources efficiently.

Recently Anat Admati and Martin Hellwig published an excellent “The Bankers’ New Clothes” 2013, though I think “The Regulators’ New Clothes” would have been a better title. But, in one passage they write “Whatever merits of stating equity requirements relative to risk-weighted assets may be in theory, in practice…” 

And, dear finance professors, my problem is that I have not been able to find anything yet that I would include within the “Whatever merits”. 

Besides the so fuzzy “more risk more capital, less risk less capital, it sounds logical”, do you have any idea why the regulators did that? If not, can you help me asking around? 

I mean, it is no minor thing that our whole banking system seems to be driven by a loony double consideration of perceived risks.

I mean it is no minor thing that our bank regulators have decided to favor “The Infallible” those already favored by the market and bankers and thereby discriminate against “The Risky”, like all our small businesses and entrepreneurs.