Comments on: IMF WP 14/169 "Reconsidering Bank Capital Regulation" Connel Fullenkamp and Céline Rochon

IMF Working Paper “Reconsidering Bank Capital Regulation: A New Combination of Rules, Regulators, and Market Discipline”, Connel Fullenkamp and Céline Rochon, September 2014.

Its abstract: 

“Despite revisions to bank capital standards, fundamental shortcomings remain: the rules for setting capital requirements need to be simpler, and resolution should be an essential part of the capital requirement framework. We propose a new system of capital regulation that addresses these needs by making changes to all three pillars of bank regulation: only common equity should be recognized as capital for regulatory purposes, and risk weighting of assets should be abandoned; capital requirements should be assigned on an institution-by-institution basis according to a regulatory (s,S) approach developed in the paper; a standard for prompt, corrective action is incorporated into the (s,S) approach.

Some brief comments:

1. For someone who like me has for more than a decade profoundly objected the whole concept of risk-weighted capital requirements for banks, a recommendation that “risk weighting of assets should be abandoned”, is of course very much welcomed.

But, that said, if the recommendation is not based on a total understanding of what is really wrong with risk-weighing, it is difficult to develop adequate remedies… and most specially to be able to transition from here to there, without causing serious and dangerous disruptions to banks and economy. 

And, unfortunately, that is the case with this paper. It is solely written from the very limited perspective of trying to make banks safe, ignoring banks’ fundamental role of allocating bank credit efficiently to the real economy.

Let me briefly resume my argument. Risk-weighing, based on credit risks which are cleared by banks through interest rates and amounts of exposure, and which result in lower capital requirements for holding assets which ex ante are perceived as safe when compared to assets which ex ante are perceived as risky; make banks able to earn much higher risk adjusted returns on “safe” assets than on “risky” asset; something which distorts and causes banks to lend too much and at too low rates to “the safe”, and too little and at too high relative interest rates to “the risky”.

And all this derives from the sad fact that nowhere in all current Basel bank regulations, do we find a word about what is the purpose of banks. “A ship in harbor is safe, but that is not what ships are for.” John Augustus Shedd, 1850-1926.

For example the paper makes the comment: “Acharya et al (2013) provides evidence that risk weights are not the right tools to use in assessing the level of bank capital requirement”. But, that paper referenced only discusses the risk weights – those that cause different capital charges - in terms of the distortion they produce in the portfolio of banks, with no mention whatsoever of the, directly corresponding, distortions in the allocation of bank credit. That is evidenced when the Acharya paper comments “Also note that the portfolio distortion problem does not exist for banks that are only leverage-constrained since the additional charges are the same for all assets.”

Note: The existence of “additional charges” are there openly recognized and yet no one seems concerned about how these, by favoring “The Infallible”, would odiously discriminate against the fair access to bank credit of “The risky”.

2. And the proposed alternative: “capital requirements assigned on an institution-by-institution basis according to a regulatory (s,S) approach developed in the paper”, which is of course also based on ex ante perceived risks, if it does not start from defining the purpose of banks, and how to avoid the distortions in credit allocation, could even make these much worse.

3. The proposed alternative: “capital requirements assigned on an institution-by-institution basis”, no matter how much authors believe “our framework aims to significantly improve market discipline and focus it directly on the regulators”, is plain dangerous as it increases the discretionary powers of regulators, something that will, sooner or later, one way or another lead to abuse. 

“This will enable market participants to monitor regulators’ actions” What market participants? It really sounds like an insult to someone who has in vain tried to get an explanation for the “portfolio invariant ex-ante perceived credit risks and nothing but the portfolio invariant ex-ante perceived credit risks already previously weighted for, weighted capital (equity) requirements for banks”