Thursday, August 15, 2013
Many bank executives and some regulators hold that not using risk-weights when calculating capital requirements for banks can tempt banks to move towards riskier loans that earn higher returns but are more likely to result in losses.
That is complete baloney and this so convenient for some banks myth needs to be urgently debunked.
As a start we just need to understand that any “perceived risk” can be cleared for by bankers by the interest rate they apply, the size of the exposure and other contracting terms.
And so the truth is that lower capital requirements, permitted for something perceived as “absolutely safe”, and which allows the banks to achieve a higher expected risk-adjusted return on equity on those assets, will only help to push the banks to create excessive exposures, while holding very little capital, to precisely that type of exposures which have caused all the bank crises in history, namely assets which were ex-ante perceived as safe but that ex-post turned out to be risk. And, if in doubt, just try to find one single major bank crisis that has resulted from excessive exposures to what was ex-ante, not ex-post, perceived as risky.
The different capital requirements based on perceived risk which so much favors the access to bank credit of The Infallible and thereby discriminates against The Risky, also completely distorts the allocation of bank credit in the real economy.
What would for instance a regulator, in the US or in Europe, answer if asked: Sir, why are the capital requirements for our banks lower when they lend to a foreign sovereign, than when they lend to our national small business and entrepreneurs, those who have never ever set off a major bank crisis?