Monday, August 22, 2016

Basel Committee’s mindboggling naiveté: Banks, thou shall not misbehave and fudge to lower your capital requirements

In the “Statement on capital arbitrage transactions” Basel Committee newsletter No 18 of June 2016 we read:

“Transactions that are designed to offset regulatory adjustments employ a variety of strategies. For example, these may include: (1) the issuance of senior or subordinated securities with or without contingent write off mechanisms; (2) sales contracts that transfer insufficient risk to be deemed sales for accounting purposes; (3) fully-collateralised derivative contracts; and (4) guarantees or insurance policies. These types of transactions… can have the effect of overestimating eligible capital or reducing capital requirements, without commensurately reducing the risk in the financial system, thus undermining the calibration of minimum regulatory capital requirements.

Banks should therefore not engage in transactions that have the aim of offsetting regulatory adjustments.”

What a mindboggling naiveté! While regulators allow banks to hold less capital against assets perceived, decreed or concocted as safe, and the risk-adjusted return on equity is how banks compete for capital (and bonuses), how can they think banks will not do their utmost to lower the required equity?

PS. Children, listen to your Basel nannie, though there is ice-cream and chocolate cake in the fridge, she still expects you to eat the spinach and the broccoli.

PS. You want your children not to arbitrage and eat of everything... blend it all together.

PS.You want your banks not to arbitrage... set one capital requirements for all assets.