The Basel Committee used expected credit losses as a direct proxy for all the unexpected. Loony eh?

Steven Solomon in “The confidence game” Simon and Schuster 1995 writes about “who the central bankers are, how they have shaped the course of economic and political events in the past fifteen years, why their influence relative to elected political leaders has reached a historical zenith, and how it reveals one of the greatest pressing dangers facing free democracy.

And beginning Solomon quotes The Testament of Beauty by Robert Bridges with:

Our stability is but balance, and conduct lies

In masterfully administration of the unforeseen

And later Solomon writes: “On September 2, 1986, the fine cutlery was laid once again at the Bank of England governor’s official residence at New Change… The occasion was an impromptu visit from Paul Volcker… When the Fed chairman sat down with Governor Robin Leigh-Pemberton and three senior BoE officials, the topic he raised was bank capital…

At dinner the governor’s hopes had been modest: to find areas of sufficient convergence of goals and regulatory concepts to achieve separate but parallel upgrading moves… 

Yet the momentum it galvanized… produced an unanticipated breakthrough of a fully articulated, common bank capital adequacy regime for the United States and United Kingdom. This in turn catalyzed one of the 1980’s most remarkable achievements – the first worldwide protocol on the definitions, framework, and minimum standards for the capital adequacy of international active banks…

They literally wiped the blackboard clean, then explored designing a new risk-weighted capital adequacy for both countries… 

It included… a five-category framework of risk-weighted assets… It required banks to hold the full capital standard against against the highest-risk loans, half the standard for the second riskiest category, a quarter for the middle category, and so on to zero capital for assets, such as government securities, without meaningful risk of credit default.”

And which, in other words, means that these regulators determined the capital bank needs to hold to cover for unexpected losses, was to be a direct function of the ex ante perceived risk of expected credit losses. The expected substituting for the unexpected... loony eh!

Since the expected is already considered by bankers when setting the interest rates and the size of exposures, having it to also stand in for the unexpected in the capital, meant the expected got to be excessively considered. And any risk, even if perfectly perceived, causes the wrong actions, if excessively considered. What did we do to deserve such credit risk adverse fools?