12 years after Basel II, ECB sees faults in risk weighted capital requirements for banks, but still doesn’t get it
ECB has published a document titled “The limits of model-based regulation” ECB Working Paper 1928, July 2016. In it the authors find that risk-weighted capital requirements based on sophisticated models applied by big banks, are basically dangerous and worthless.
Of course that regulation is worthless, it does not serve any useful purpose, and only increases the probabilities of financial instability.
But from its “Non-technical summary” it is harrowing to see that they still do not fully understand why these risk weighted capital requirements are dangerous; not only for the big banks with their models, but also for the smaller that apply the standard approach risk weights declared by the Basel Committee; and also, primarily, for the real economy.
For a starter it declares: “In recent decades, policy makers around the world have concentrated their efforts on designing a regulatory framework that increases the safety of individual institutions as well as the stability of the financial system as a whole.”
And so the first observation is: Who gave policy makers the right to concentrate on designing a regulatory framework that completely ignores whether the allocation of bank credit to the real economy is efficient or not? Is the real economy to serve banks or are the banks to serve the real economy? “A ship in harbor is safe, but that is not what ships are for.” John A Shedd, 1850-1926
Then it states: “an important innovation has been the introduction of complex, model-based capital regulation that was meant to promote the adoption of stronger risk management practices by financial intermediaries, and ultimately to increase the stability of the banking system”... “banks that opted for the introduction of the model-based approach experienced a reduction in capital charges and consequently increased their lending by about 9 percent relative to banks that remained under the traditional [standard risk weights] approach”... “Back-of-the-envelope calculations (abstracting from risk-based pricing of the cost of capital) suggest that underreporting of PDs allowed banks to increase their return on equity by up to 16.7 percent”
How come regulators believed the adoption of “stronger risk management practices by financial intermediaries” would trump the maximization by banks of their risk-adjusted returns on equity? This is like given children a book with indication of calories and expecting them to stay away from the chocolate cake. Worse, in the case of the big banks applying their internal models, it was like allowing the children to calculate on their own the calories of the chocolate cake they desire. How mind-boggling naive are regulators allowed to be?
From the conclusion “Certainly, one would expect less of a downward bias in risk estimates if model outputs were generated by the regulator and not the banks themselves” one could believe the authors favor the standard approach risk weighting.
Of course that is better than the sophisticated modelling by the big banks, which only guarantees Too Big To Fail Banks. But the all the principal faulty characteristics of the whole risk weighting process remain intact even then... and are still ignored:
Like why basing capital on ex ante perceived credit risks, when all major bank crises have resulted either from unexpected events or excessive exposures to what was ex ante perceived as safe?
Like why if banks by the size of the exposures and interest rates already clear for perceived risk, should they also be cleared for in the capital? Do not regulators understand that any risk, even if perfectly perceived, leads to the wrong actions if excessively considered?
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