Thursday, August 29, 2013

The condensed dark truth about the risk weighting in current Basel bank regulations

Before the current risk-weighted capital requirements for banks, the risk adjusted returns on bank equity were basically the same for all loans, and the ex ante perceived risk was cleared for in interest rates, amount of exposure, duration and other contractual terms.

But with the introduction of risk weighted capital requirements for banks, which re-cleared for the same ex ante perceived risk, in the way of less-risk much-less-capital, more-risk more-capital, the expected risk adjusted returns on bank equity are now much much higher when lending to “The Infallible” than when lending to “The Risky”.

And that results in that banks will lend, even more than usual, at even lower rates than usual, to sovereigns, housing and the AAAristocracy; and even less than usual, at even higher rates than usual, to medium and small businesses, the entrepreneurs and start-ups.

Of course there is an initial economic high when all that fresh bank credit flows to “The Infallible”, I call it economic froth, but, after that, the real economy will been going down, down, down, because, if “The Risky”, namely the medium and small businesses, the entrepreneurs and the start-ups, do not get access to credit in competitive terms, then there is nowhere else the real economy can head.