Sunday, October 30, 2016

With risk weighted capital requirements, Basel Committee’s regulators fed the banking system brutish misinformation

If you have $100.000 to invest you might invest more and at a lower interest rate in what you perceive as safe, as compared to how you would invest in what you perceive as risky. But, even so, you would never ever think of your $1 invested in what you perceive as safe, to be any different than the $1 you have invested in what you perceive as risky. 

That is not the current case with banks. With the risk weighed capital requirements for banks, they have been told that $1 invested in what is perceived as safe, is worth much more than $1 invested in what’s is perceived as risky. That because regulators allow banks to leverage the former $1 much more than the latter; which means that $1 invested in what is ex ante perceived, decreed or concocted as safe, produce the banks a much higher expected risk-adjusted return on equity, than $1 invested in what is ex ante perceived or decreed as risky.

For instance Basel II, with its 8% basic capital requirement set a 20% risk weight for AAA rated private assets and 100% risk weights for unrated SMEs. That allow banks to leverage their equity, and the support they received from society 62.5 times with AAA rated assets and only 12.5 to 1 with loans to SMEs. That resulted into that for a bank to lend to a SME, as compared to lending to an AAA rated borrower, carried the cost of 50 times lesser leverage opportunities.

That signified that banks, in order to keep shareholders happy with high risk adjusted returns, and management bonuses high, had to keep to what was perceived as safe and abandon lending to what was perceived as risky.

So banks no longer finance the “riskier” future, they only refinance the “safer” past.

So banks are dangerously overpopulating safe havens and, for the real economy, dangerously underexploring riskier bays.

So banks are gladly financing those “safe” basements where jobless kids can live with their parents, and not those “risky” SMEs that stand a chance to create the jobs that could allow the kids to afford to become parents too. 

Damn those regulators who manipulated and still are manipulating the allocation of bank credit this way. They should be shamed and banned forever.