Sunday, January 5, 2014

An alternative "Abstract" for my paper

The expected losses of a bank should normally be covered by its operations. The capital requirements are imposed by regulators primarily to cover for the “unexpected losses”.

But the risk-weighted capital requirements of Basel II and III have nothing to do with “unexpected losses” and all to do with a double counting of “expected losses”.

In fact an “Explanatory note of the risk weights function” July 2005, clearly spells out that: 

Because “Taking into account the actual portfolio composition when determining capital for each loan - as is done in more advanced credit portfolio models - would have been a too complex task for most banks and supervisors alike… The model [is] portfolio invariant and so the capital required for any given loan does only depend on the risk of that loan and must not depend on the portfolio it is added to”

In other words, a bank portfolio with extremely dangerous concentrations in what ex ante is perceived as “absolutely safe” will be deemed much safer than an extremely well diversified portfolio of assets perceived as “risky”.

And the note explains: “In the context of regulatory capital allocation, portfolio invariant allocation schemes are also called ratings-based. This notion stems from the fact that, by portfolio invariance, obligor specific attributes like probability of default, loss given default and exposure at default suffice to determine the capital charges of credit instruments. If banks apply such a model type, they use exactly the same risk parameters for expected losses (EL) and unexpected losses (UL), namely probability of default (PD), loss given default (LGD) and exposure at default (EAD).”

And so in fact there is never a provisioning for unexpected losses, but only a double provisioning for expected losses. 

The net result of these capital requirements are then that banks will be earn a much higher “perceived risk” adjusted return on equity when lending to those perceived as “safe” than when lending to those perceived as “risky”. And that causes a huge regulatory discrimination in favor of those perceived as “absolutely safe” and against those perceived as “risky”.

And all this the Basel Committee has done even admitting to that “intuition tells that low PD borrowers (safer) have, so to speak, more “potential” and more room for down-gradings than high PD (riskier) borrowers”. 

But, instead of considering this larger unexpected loss potential in the capital requirements, they postpone any adjustments to the moment of when a downgrading occurs, completely ignoring that a downgrading is nothing but the unexpected increase of expected losses.

This regulatory mistake, by pushing excessive bank credit to what was perceived as “absolutely safe” caused the current crisis, and by not allowing for sufficient bank credit to flow to the "risky", impedes us from getting out of the crisis.

PS. The current version of the paper