Tuesday, September 8, 2015
The Circle of Reason will ask: "What did they do?"
My answer is that they decided banks needed to hold more capital against assets perceived as risky than against assets perceived as safe.
The Circle of Reason might then say: "But that sounds fairly reasonable, so why is it wrong?"
So here is a non-exhaustive list of reasons, in no particular order:
Banks already clear for perceived credit risk by means of risk premiums charged, size of exposure and other contractual terms so re-clearing for the same perceived risk only distorts.
Instead of looking at the risks of how banks managed the perceived risks of their assets, the regulators also focused on the same perceived risks.
Perceived credit risks are to be managed by the banks and if they cannot do that they should close down as fast as possible. Bank capital is to cover for unexpected losses and so to set the requirements of it based on the expected losses derived from perceived risks make absolutely no sense whatsoever.
The regulators decided that the capital requirements should be portfolio invariant, meaning these had nothing to do with the size of any bank exposure, meaning that all the benefits from diversification were ignored, meaning that they did not know one iota about what they were doing.
To top it up bank regulators decided that the risk weight of sovereigns was to be zero percent while the risk weight for the citizens that make up that sovereign was to be 100 percent, which, unless you are a runaway statist or communist, makes absolutely no sense.
The regulators never understood that allowing banks to have less capital against The Safe, would allow banks to leverage the equity and the support of society much more on loans to The Safe, which allowed banks to earn much higher risk adjusted returns on equity when lending to The Safe than when lending to The Risky.
The regulators regulated the banks without defining what the purpose of banks is, which meant that they for instance ignored the whole topic of allocating credit efficiently to the real economy. Only that should suffice to earn them a place in the Hall of Shame.
The regulators never studied what had caused major bank crises and so confused the ex ante perceived risks with the ex-post real risks. Had they done so they would have noticed that major bank crises result from excessive exposures to something ex ante perceived as safe… and so their capital requirements should perhaps be 180°different, higher for what is perceived safe than for what is perceived risky.
The regulators just focused on the bust event of an economic cycle, not caring about what the whole boom-bust cycle produced… and so they totally ignored that risk-taking is in fact the oxygen of any development.
In these days in which inequality is much discussed the regulators never understood that denying a fair access to bank credit to those perceived as risky, is a potent inequality driver.
If they absolutely wanted to distort, in order to show they were working, why did they not distort with a purpose, like basing the capital requirements on job-creation and sustainability ratings?
The regulators awarded so much power to some human fallible credit rating agencies so that credit ratings became a huge source of systemic risk that would travel at globalized speeds.
The regulators have, now soon ten years after a crisis that was initiated by excessive exposure to AAA rated securities, sovereigns like Greece, real estate in Spain and much other assets that all shared the commonality of generating very low capita requirements for banks, not yet been able to understand the causality.
I could probably go on for quite some time, but this should be enough to at least establish The Basel Committee (and the Financial Stability Board) as serious candidates to be inducted to The Circle of Reasons' Hall Of Shame.
A former Executive of the World Bank (2002-2004)