Sunday, February 8, 2015

Analysis of current equity requirements for banks in light of ex ante perceptions of risks and ex post realities

The Kurowski Matrix:

1st: ex ante Risky – ex post Safe; the results for banks (and the economy) are Positive

2nd: ex ante Risky – ex post Risky; the results for banks can be Moderately Negative. The riskier the ex ante perceptions the smaller the ex post consequences.

3rd: ex ante Safe – ex post Safe; the results for banks are basically Neutral.

4th: ex ante Safe – ex post Risky; here the results for banks are Potentially Extremely Negative as the distance between the initial ex ante perception and the ex post sad reality can be the largest. 

And now the horrible truth!

The Basel Committee set their portfolio-invariant-credit-risk-weighted-equity-requirements for banks by far the lowest, for what was perceived as the safest assets, the 4th quadrant, precisely where the potential size of disaster is by far the largest. 

The Basel Committee committed that horrible mistake because they used the risks of bank assets, instead of the risks that banks would not be able to manage the risks of those assets. 

In other words the capital requirements for banks are based solely on ex ante perceived risks of assets and not on ex post observed risks for banks.

And their mistake was compounded by the fact they did not understand, or did not care one iota about, the fact that different equity requirements for different assets seriously distorts the allocation of bank credit to the real economy. 

Conclusion: It is clear the Basel Committee, and the Financial Stability Board, had no idea about what they were doing… and that they still don´t.