Friday, July 29, 2016

Regulatory risk-weights: The sovereign = Zero percent and We the (risky) People = 100%. In America?

I am not an American, and I am not well versed on its Constitution, and there is one issue which has for a long time been a mystery to me. 

How on earth could America, in 1988, as a signatory of the Basel Accord, accept that for the purpose of setting capital requirements for banks, the risk-weight for the sovereign, meaning the government, was going to be zero percent, while the risk-weight for the citizen, meaning We The People was set at 100%; and all without a major discussion?

I know that “sovereigns” currently means the government but, from reading for instance Randy E. Barnett’s “Our Republican Constitution”, one could have expected some debate about something that is akin to risk weighing the King with an "infallible" 0%, and his subservients with a "risky" 100%.

Barnett's book states that Justice James Wilson, in the Chisholm v. Georgia case of 1793, opined that “To the Constitution of the United States the term Sovereign is totally unknown…and if the term sovereign is to be used at all, it should refer to the individual people”. And the book also frequently refers to the importance of the required consent of the people, which of course is also a thorny issue. 

And, since those risk-weights effectively permit banks to leverage their equity much more when lending to the sovereign, than when lending to the citizen; banks will earn higher risk adjusted returns when lending to the sovereign than when lending to the citizens; and so banks will de facto, sooner or later, lend much too much to the sovereign and much too little to the citizens… and I can simply not fathom how citizens, be they individual or majority, could give their consent to something like that.

De-facto those risk weights signify that regulators believe that government bureaucrats can make better use of bank credit than citizens… it is statism running amok.

But it became even worse. In 2004, in Basel II, regulators also made a distinction between those private who had great credit ratings, like AAA to AA, and who received a 20% risk-weight, and for instance those who had no ratings, and who kept their 100% risk weight. That to creates a sort of AAA-risktocracy that does not square well with the Constitution’s “No Title of Nobility shall be granted by the United States.

But even without entering into constitutional issues, there is even a current law that seems to prohibit this type of discrimination, but that is not applied to bank regulations. And I refer to the Equal Credit Opportunity Act: “Regulation B”.

So in the land in which its Declaration of Independence states: “We hold these truths to be self-evident, that all men are created equal, that they are endowed by their Creator with certain unalienable Rights, that among these are Life, Liberty and the pursuit of Happiness.”, I just must ask: How could regulators dare to decree such regulatory inequality?

And to top it up, the current risk-weighted capital requirements for banks, more ex ante perceived risk more capital – less risk less capital, are arbitrary and irrational. And that because no major bank crises have ever result from the build up of excessive dangerous bank exposures to something perceived as risky, that has always happened with something, erroneously, perceived as very safe. If you want to understand how really crazy these bank regulations are, here is a brief memo.

And frankly what would a Governor answer to this question: Why can our banks leverage their equity lending more to a foreign sovereign or a foreigner with a high credit rating, than when lending to us, the local SMEs and entrepreneurs?

No! America would never have become what it is, had it had this type of risk averse discriminatory bank regulations before.

And by the way the Dodd Frank Act, in all its 848 pages, surrealistically, does not mention the Basel Committee nor the Basel Accord, not even once.

PS. In his book Professor Barnett defends Federalism from the perspective of making diversity more possible. That rhymes well with what I stated at the World Bank as an Executive Director 2002-04: "A mixture of thousand solutions, many of them inadequate, may lead to a flexible world that can bend with the storms. A world obsessed with Best Practices may calcify its structure and break with any small wind”