Basel II and III risk weighted capital requirements for banks, is a horrible regulatory nightmare.

HERE THE REAL TERMINOLOGY NOT THE ABRIDGED DUMB ONE

“Risk weighted capital requirements for banks”, meaning more capital (equity) for what is perceived as risky less capital (equity) for what is perceived as safe, sounds so logical and so reassuring. 

Until... you understand what these really mean!

First, the risk that is weighted for if of course the ex-ante perceived risk, something which does not necessarily mean that is the same as the real ex-post risk.

And so a more accurate terminology should be “the ex-ante perceived risk weighted, capital  (equity) requirements for banks”

Second, the risk that is weighted for has noting to do with the health of the economy, the sustainability of mother earth, job creation for our young or any other such other laudable concern. It has only to do with the credit risks of the assets, of the borrowers.

And so a more accurate terminology should be “the ex-ante perceived credit risk and nothing but the ex-ante credit risk, weighted capital (meaning equity) requirements for banks”

Third, but those perceived credit risks have already been weighted for by the banks who have of course also perceived these, among other by using the available credit ratings, when determining what size of exposure they are willing to accept, at what interest rates, and in what other terms.

And so now a more accurate terminology should be “the ex-ante perceived credit risk and nothing but the ex-ante perceived credit risk already previously weighted for, weighted capital requirements for banks”

Fourth, but the risk weighted for has exclusively to do with the ex ante perceived credit risk of the borrower and has nothing to do with how large an exposure could be, meaning how much of the bank’s portfolio is exposed to that risk.

And so now a more accurate terminology should be “the portfolio invariant ex-ante perceived credit risk and nothing but the portfolio invariant ex-ante perceived credit risk already previously weighted for, weighted capital (meaning equity) requirements for banks”.

And, described that way, anyone should be able to understand how this regulation:

Odiously distorts the allocation of bank credit in the real economy, by having banks lending way too little at way too relative high interest rates to those perceived as “risky”, some of whom are those who most need bank credit, and way too much at way too low interest rated to those perceived as “absolutely safe”, some of whom are those who least need bank credit.

And makes sure that when an ex-ante perceived as absolutely safe asset, and which therefore will probably represent a large part of the portfolio, ex post turns out to be very risky, something which will always happen sooner or later, the bank will stand there naked with little capital (equity) to cover up with

What a nightmare!