Monday, August 3, 2015

What were (are) regulators in the Basel Committee smoking when they set their capital requirements for banks?

The capital requirements for banks are primarily, almost exclusively, to cover for Unexpected Losses (UL), since the Expected Losses (EL) are covered by means of risk premiums, size of exposures and other terms.

And this the bank regulators know as we read in “An Explanatory Note on the Basel II IRB Risk Weight Functions”.

It states: “Banks are expected in general to cover their EL on an ongoing basis, e.g. by provisions and write-offs, because it represents another cost component of the lending business. The UL, on the contrary, relates to potentially large losses that occur rather seldom. According to this concept, capital would only be needed for absorbing UL… [and so] it was decided to follow the UL concept and to require banks to hold capital against UL only.”

But then the strangest thing happened! The regulators, when calculating those UL decided to do this all with formulas that used the EL, and so, inexplicably, they came up with capital requirements that indicate the potential of higher UL for higher EL.

And that just cannot be. It is clear that the safer an asset is perceived, the larger its potential to deliver UL. It is also clear that many of UL in a bank can derive from causes completely unrelated to the intrinsic riskiness of assets… like for instance a cyber-attack.

And, as a result of the confusion, the current capital requirements for banks are much higher for assets perceived as “risky” than for assets perceived as “safe”, with the following consequences:

Banks are able to create huge exposures, against very little capital, to what is ex ante perceived as safe but that ex post could turn out risky, and that is precisely the stuff major bank crises are made of.

The allocation of bank credit is much distorted since using Mark Twain’s analogy bankers will now lend out the umbrella even more than usual when the sun is out and want it back faster than ever as soon as it looks like it is going to rain.

Just look at how much those in the sun, like AAA rated securities, real estate and governments (like Greece) have been able to borrow, when compared to the much tightened borrowing conditions for SMEs and entrepreneurs.

And so nowadays, thanks to our regulators, banks are not financing the riskier future but are mainly busy refinancing the safer past… Friends, where are the jobs for our grandchildren come from?