Mr. Stefan Ingves… I do seriously disagree with your “risk-based capital adequacy ratios”, and I dare you to debate it.

Mr. Stefan Ingves the Chairman of the Basel Committee on Banking Supervision delivered a speech titled “Banking on Leverage" during a High-Level Meeting on Banking Supervision, held Auckland, New Zealand, 25-27 February 2014.

In it Ingves stated: “Risk-based capital adequacy ratios have been the cornerstone of the Basel framework since it was introduced 25 years ago. Capital adequacy ratios measure the extent to which a bank has sufficient capital relative to the risk of its business activities. They are based on a simple principle: that a bank that takes higher risks should have higher capital to compensate. Of course, there are plenty of challenges in measuring risk -- something I will come back to shortly -- but I have yet to meet anyone who seriously disagrees with that simple principle.”

Well I am one who seriously disagrees with that principle… and I dare him to meet me and debate the issue.

A bank, when taking risks, high or low, should compensate for any probable expected losses, by means of interest rates (risk premiums), the size of the exposure, and other terms, like the duration of the loans and guarantees.

And, if the banker does his job well, and adjusts adequately to the risk, then capital has absolutely no role to play in that. And, if the banker does not know how to do his job well, and does not adjust adequately to the risks, then he should fail, the sooner the better for all, so that the bank accumulates as little combustible mistakes as possible.

But a bank regulator, like the Basel Committee, cannot and should not, entirely trust that all risks are being duly perceived by the bankers because, as we all know, there are such things as hidden risks and unexpected losses.

But any hidden risks and unexpected losses cannot be approximated by means of the perceived risks and the expected losses… in fact it is what is perceived as absolutely safe, what is expected to produce the smallest losses, and which therefore can lead to very high bank exposures, which always produce the most dangerous unexpected losses which pose a threat, not only to an individual bank, but to the whole banking system.

And so bank regulators should not require banks to have higher capital to compensate for higher perceived risk, as they do now, but require banks to have a reasonable level of capital in defense of what is not perceived… and since they can not presume to know about the hidden risks of unexpected losses, then they have no other alternative than to set one single capital requirements for all assets, independent of their perceived risks.

To have an idea of how much current risk based capital requirements miss the target, if anything, one could even make an empirical case for setting the capital requirements slightly higher for what is perceived as "absolutely safe" than for what is seen as "risky".   

And that would also eliminate a great source of distortion. The current capital requirements, more perceived risk more capital, less perceived risk less capital, translates into allowing banks to earn much higher risk-adjusted returns on equity on assets deemed as safe, than on assets deemed as risky… and that makes it impossible for banks to perform their function of allocating efficiently bank credit to the real economy.

Basel Committee, Financial Stability Board, know that Your risk-based capital ratios are stopping the banks to finance the risks our future needs to be financed, and only have banks refinancing the safer past. Our young, who now because of your regulations might end up being a lost generation, will hold You all accountable.

As I see it… anyone who allowed banks to leverage 62.5 to 1 on assets, only because these had an AAA rating… or allowed banks to lend to the “infallible sovereigns” against no capital at all, like the Basel Committee allowed for in Basel II, is just not fit to be a regulator. Capisce Mr. Ingves?

PS. Stefan Ingves also states that “The world's largest listed non-financial companies fund their assets around 50:50 with debt and equity. In banking, a more common ratio is 95:5” Let it be clear that 95:5 is 19 to 1 debt to equity… never ever, in the history of banking before the Basel Committee’s risk based capital ratios, have banks remotely been allowed to leverage this much, knowingly.