Sunday, March 6, 2016
The pillar of current bank regulations is the credit risk weighted minimum capital requirements for banks; more perceived credit risk-more capital and less risk-less capital.
For instance, in Basel II of 2004, paragraph 66, we find the following risk weights for claims on corporates depending on their credit assessment.
AAA to AA rated = 20%; A+ to A- = 50%; BBB+ to BB- = 100%; Below BB- = 150%; Unrated = 100%
Since the basic capital requirement in Basel II was 8 percent then the respective minimum capital requirements were:
AAA to AA rated = 1.6%; A+ to A- = 4%; BBB+ to BB- = 8%; Below BB- = 12%; Unrated = 8%
And that translates into that banks were allowed to leverage capital (equity) as many times as follows:
AAA to AA rated = 62.5; A+ to A- = 25; BBB+ to BB- = 12.5; Below BB- = 8.3; Unrated = 12.5
That is dumb and that is dangerous.
The dumb part is easily evidenced by just asking: Who can think that what has a credit rating of below BB-; which means moving from “highly speculative” through “extremely speculative” and up to “default imminent”, is more dangerous to banks than any of the other “safer” assets?
With a reference to Mark Twain’s saying that “bankers want to lend you the umbrella when the sun shines and take it back when it looks like it is going to rain”, one could even make a case for the totally opposite, a 20% risk weight for assets rated below BB- and a 150% risk weight for assets rated AAA to AA.
And clearly no major bank crises have ever resulted from excessive exposures to risky type below BB- exposures; these have always resulted from excessive exposures to something ex ante perceived as “safe” but that ex post turned out to be risky. In fact it only guarantees that if something really bad happens with an excessive exposure to something erroneously perceived as safe, that banks will stand there naked, with especially little capital to cover them up with.
But it is also very dangerous, primarily because it distorts the allocation of bank credit to the real economy.
By allowing banks to leverage more with the Safe than with the Risky, banks will be able to earn higher expected risk adjusted returns on equity with the Safe than with the Risky; which means banks will lend more than it would ordinarily lend to the Safe and less than it would ordinarily lend to the Risky… and that cannot be good for the real economy.
The day someone calculates how many small loans to SMEs and entrepreneurs have not been awarded because of this silly regulatory risk aversion; and we think of all the opportunities for job creation that have been lost; we will all cry... and our young could get mad as hell, as they should.
But the real story is even worse. Regulators gave the sovereigns (governments) a risk weight of zero percent; which means they think government bureaucrats are worthier of bank credit than those in the private sector. That is pure unabridged statism.
And since these regulations discriminate against the bank credit opportunities of the Risky, it also serves as a potent driver for increased inequality.
There is soon a decade since that crisis which resulted from excessive exposures to AAA rated securities, and to sovereigns like Greece, broke out; and the arguments here presented are not even being discussed. If that lack of accountability is not scary, what is?