Monday, February 23, 2015

The sad tale about the rookie instructors in the Basel Committee's bank driving school

More perceived credit risk more bank equity… less perceived credit risk less bank equity. Does that not sound logical? It does, and that is precisely why intuition manages to overtake understanding.

Let me try to explain it all with the help of the following image of a two driving wheel car sometimes used by driving schools.

Suppose the driving student is an expert driver, let’s call him a banker, and the driving instructors  is  a rookie who does not know even how to drive well on his own, let’s call him the regulator.

And let us also suppose that the car came with a manufacturing defect, namely the instructor's driving wheel not overriding the student's... and nobody at the driving school cared to check for that.

And now they are out on the street. The banker sees a credit risk danger, and averts it by turning his driving wheel, taking on small exposures and setting the risk premiums high so as to compensate for the added risk.. all as one should normally drive. 

But, seeing the same perceived credit risk, the scared rookie regulator also turns his driving wheel, that of equity requirements. The result will be a dangerous over-reaction to perceived credit risks… either too much steering the car into safety or too much steering it away from the risks that are natural when driving.

You might argue the regulator has accelerating and breaking pedals too he could use. Not so! In this case the regulators of the Basel Committee stated that, making the driving also depend on the speed, was much too complicated for them, and so the driving lessons were to be “portfolio invariant”.

And with bankers already hating velocity where risks seem high… they now do almost no lending at all to “risky” SMEs and entrepreneurs, to those who are those most in need of fair access to bank credit.

And with bankers loving to speed when it seems safe, they crash, where they usually crash, someplace seemingly “very safe”. Unfortunately, now the crashes causes much more tragedy because, when driving around in AAA rated securities, sovereigns like Greece, real estate in Spain and similar "safe"terrains, they are now allowed to drive with little use of safety belts, bank equity.

And here we are biting our nails, thinking about what still lies waiting for us around ultra-safe corners.