Tuesday, April 21, 2015
Anjana Ahuja yesterday pointed out in the Financial Times that you have launched the #ParliamentCounts campaign, offering all MPs a free training course in statistics. What a marvelous and commendable Statistical Literacy Initiative.
In reference to it may I also get your attention to briefly expose a very serious error in current bank regulations? The error is not only making our banks more dangerous, but is also seriously distorting the allocation of bank credit to the real economy. And, you the Royal Statistical Society, can definitely help to do something about it.
I refer to the pillar of current bank regulations, namely to what is known as the capital requirements for banks; or more precisely described the portfolio invariant credit-risk-weighted equity requirements for banks.
Its essence is to force banks to hold more equity against assets perceived as risky than against assets perceived as safe. Although it intuitively sounds correct, the following simple analysis of the only three possible outcomes, should suffice to illustrate the huge mistake.
Outcome 1: The perceived credit risk is correct. Is this dangerous for banks? It should not be.
Outcome 2: The real credit risk turns out to be less that the perceived credit risk. Is this dangerous for banks? Absolutely NOT!
Outcome 3: The ex post credit risk turns out to be higher than the ex ante perceived credit risk. Is this dangerous for banks? YES!
And of course, the smaller the ex ante perceived credit risk has been perceived, the larger is its ex post potential danger.
Therefore regulators should have based their credit risk weighted equity requirements for banks, on the consequences of the real credit risks turning out to be higher than the perceived credit risks.
Unfortunately, the regulators based their portfolio invariant credit risk weighted equity requirements for banks solely based on Outcome 1, namely on the perceived risks being correct.
And now, facing clear evidence of how wrong their regulations are from a bank safety point of view, and of how much these credit-risk differentiated equity requirements distorts the allocation of bank credit, the regulators still fail to even acknowledge the existence of this mistake.
Dear members of the Royal Statistical Society, would you please help me to shame the regulators into waking up, before even more damaged is done?
I am absolutely sure that if you send the Basel Committee, and the Financial Stability Board, and the IMF, a brief memo suggesting that instead of looking at the risk of the assets of banks, one needs to look at the risks of banks not being able to manage the risks of the assets of the banks, you would have significant more impact than what my little voice has been able to achieve during the last decade.
Please do this for the sake of our children and grandchildren and who are the ones who will most suffer the impact of this horrible regulatory mistake.
PS. You will have to excuse me but, not being able to control my obsession with making this horrible mistake known to the world, I am making this letter public on my blog and on some social media.
A former Executive of the World Bank (2002-2004)