Tuesday, December 16, 2014

What would have happened if Basel capital requirements for banks were lower for what’s “risky” than for what’s “safe”?

Many things! Among other:

First, since banks would then not be able to leverage their equity as much as they could with assets perceived as “absolutely safe”, then the risk of traditional bank crises those which result from excessive exposures to what is erroneously perceived as absolutely safe, would of course be lower. And, to top it up, if these were to occur, they would at least find banks covered with much more equity…not standing there bare-naked as now.

Second, the whole procedure of how to game the regulations would change 180 degrees. Instead of having a vested interest in dressing up assets as “absolutely safe”, they would want to dress up assets as “more risky” than they are… and that process would certainly faced more objections, since borrowers and lenders would definitely not share the same objective.

Third, small businesses and entrepreneurs would find it much easier to break that curse described by Mark Twain, of bankers being those who lend you the umbrella when the sun shines and wanting it back as soon as it looks like it is going to rain.

Fourth, it would be harder for too big to fail banks to grow, since low capital requirements hormones are not as effective where it is risky than where it is safe.

Fifth, there would be more “safe” investments available, for you, for me, and for the widows and orphans.

Sadly bank regulators went for an automatic decision: “safe is safe and risky is risky”; and did not take time to deliberate sufficiently on the fact that there where too many empirical evidences that, at least in banking, “risky” was usually safe but that “absolutely safe” could turn into horribly risky.

And here we are… and bank regulators have still not learned that lesson :-(

PS. This is not a proposal... just doing some speculative thinking :-)