Wednesday, April 15, 2015

The World Bank should act as an Ombudsman for our children and grandchildren

The Basel Committee for Banking Supervision (BCBS) is in charge of developing bank regulations that are applied by more and more countries around the world. That has increased the coherence and reduced somewhat the regulatory competition between countries. Unfortunately, it has also introduced a serious systemic mistake. 

The pillar of the BCBS’s current bank regulations, is the risk weighted capital requirements for banks; something which for more preciseness, should be termed the Portfolio Invariant Credit-Risk-Weighted Bank Equity Requirements. In essence it indicates: more-credit-risk-more-equity / less-credit-risk-less-equity. 

Though intuitively it sounds very reasonable, it contains two fundamental flaws.

First, the risk-weights used are based on the default possibilities of the assets of a bank, and not on a real analysis of what has caused the major bank crises in the past. In this respect it should be noted that the bank assets more likely to cause a major crisis, are not those perceived as risky, but those that are erroneously perceived as safe.

Second, much worse, allowing banks to leverage their equity, and the explicit and implicit support these receive from taxpayers, differently, depending on credit risks already cleared for with interest rates and size of exposures, seriously distorts the allocation of bank credit to the real economy. In essence it causes the bank system to lend too much and at too low rates to what is perceived as safe, like for instance to sovereigns and what I have termed as the AAArisktocracy; and too little, at relatively too high interest rates, to what is perceived as risky, like for instance to SMEs and entrepreneurs.

The origin of this mistake can primarily be traced to that regulators never really defined the purpose of our banks, beyond that of each one having to be safe. With that the regulators completely ignored that banks represent one of the most important agents through which the society distributes its savings, and the risk-taking that the economy needs in order to move forward, so as not to stall and fall.

Any regulatory interference and distortion of how bank credit is allocated, is very dangerous, and so, if it is to be considered and allowed, one needs to make certain that, at the very least, it is in pursuit of some extremely worthy purpose.

In this respect it could be illustrative, instead of credit-risk-weights, to think about the potential-of-job-generation weights, or environmental-sustainability-weights. That would allow the banks to earn their highest risk-adjusted returns on equity, financing what could most matter to us.

The World Bank, as the world’s premier development bank, must know that risk-taking is the oxygen of any development. It therefore has an enormously important role in supervising bank regulations from the point of view of how banks: promote development, allow for fair and inclusive access to finance, advance poverty reduction, generate jobs and help to bring on environmental sustainability.

The challenges loom large. Current credit risk based equity requirements, by making it harder than need be for those perceived as “risky” to access bank credit, kills opportunities and thereby promotes inequality. And, with its bias against credit-risk, it guarantees that banks will not finance sufficiently the “riskier” future, but mostly keep to refinancing a “safer” past.

“A ship in harbor is safe, but that is not what ships are for.” John Augustus Shedd, 1850-1926.

The credit-risk-aversion present in current regulations could seem adequate for someone retired with a remaining short life expectancy. It is highly inadequate though, in fact dangerous, when set in the context of the needs of future generations. And in this respect I urge the World Bank to cast itself much more in the role of being the Ombudsman for our children and grandchildren.

And let us, somewhat older, never forget that much of what we can enjoy today, is the direct result of the willingness of the generations that preceded us to save and to take risks. We have the same duty… God make us daring!


PS. Here a statement closely related to this issue that I delivered as an Executive Director of the World Bank March 10, 2003