REVISED “The Bankers´ New Clothes”, by Anat Admati and Martin Hellwig, is a very good, and therefore [not] a dangerous book

Anat Admati and Martin Hellwig in their “The Bankers´ New Clothes” write the following about risk-weighted assets: 

“The risk-weighting approach gives the impression of being scientific”. 

“The risk-weighting approach is extremely complex and has many unintended consequences that harm the financial system. It allows banks to reduce their equity by concentrating on investments that the regulations treats as safe.” 

“The official approach to the regulation of bank equity, enshrined in the different Basel agreements is unsatisfactory… the complex attempts in this regulation to fine tune-equity requirements – for example, by relying on risk measurements and weights- are deeply flawed and create many distortions, among them a bias against traditional business lending.” 

And yet the authors when then writing “Whatever the merits of stating equity requirements relative risk-weighted assets may be in theory”, evidence they cannot or dare not free themselves entirely from believing there is something valuable in risk-weighting.

But no! There are no merits to risk-weighting, even in theory. It is just a big dumb regulatory mistake! Clearing in the capital requirements for perceived risks already cleared for on the assets side with risk premiums, amounts of exposure and other terms, just dooms banks to overdose on perceived risks, like those expressed in credit ratings, and at the same time effectively hinders the banks from performing an effective resource allocation which is so important for the society. 

The authors write “The idea behind risk-weighting is that if the assets banks hold are less risky, less equity may be needed for a bank to absorb potential losses”. What regulatory lunacy is that? If banks believe they hold less risky assets they will hold these at much lower risk-premiums, for much larger amounts, and on much more generous terms. Come on, does that sound like something which could merit banks holding less capital?

And because of their lingering doubts, what Anat Admati and Martin Hellwig propose in their book, is not so much the need of eliminating the distortion of the risk-weights, but the need for more capital. And that is why, especially as I considered it a very good book, and it includes so much of what I have argued over the last decade, I must also call it a very dangerous book.

Let me explain: If the capital requirements for a bank were zero, then risk-weights would not discriminate nor distort. It is the higher the capital requirements are, than the larger will the discrimination and the distortion the risk-weights produce. 

The authors argue: “Requiring that bank’s equity be at least on the order of 20-30 percent of their total assets would make the financial system substantially safer and healthier” Can you imagine what distortions that would cause if something like the current risk-weights are kept? 

No! and especially since I look at the banks not as separate entities in Mars, but a part of the real economy on Earth, I bet that a Basel II, 8 percent capital requirement that came with absolutely no risk-weighting, would make the financial system and the real economy substantially safer and healthier, and sturdier, than a 20-30 percent capital where regulators remain thinking of themselves as risk-managers of the world. 

And here is a previous comment on the same book

DISCLAIMER: I have just exchanged opinions with Anat Admati and she holds that contrary to what I interpreted the book makes clear that they completely oppose the pillar of Basel bank regulations, namely risk-weighted capital requirements based on perceived risk. Great! I wonder where this now leaves the Basel Committee and the Financial Stability Board, as risk-weighting is their Pillar, pride and joy.

Clearly this is a big support for the bank bill being introduced by Senators Sherrod Brown, Democrat of Ohio, and David Vitter, Republican of Louisiana. Go Brown-Vitter! Screw Basel! Enough is enough!

Its what’s safe that’s risky!