Tuesday, August 8, 2017

Capital requirements for banks should be ex ante perceived risks neutral.

Professor Steve Hanke writes: “The calculated risk that a financial institution takes is best understood by the institution itself, not the government or any outside party” “Let Banks Manage Risks, Not Regulators” Forbes July 30, 2017.

I agree: For about 600 years banks use to run their banks as if each dollar invested in any asset was worth the same. Not any longer, since Basel I, 1988 and Basel II, 2004 some assets produce net margins that regulators allow them to leveraged much more than other. That meant that banks would find it easier to obtain higher risk adjusted returns on equity on some assets, those perceived ex ante as safe, than on other, those perceived as risky.

That of course distorted dangerously the allocation of bank credit to the real economy. The 2007-08 problems resulting mainly from excessive exposures to AAA rated securities and sovereigns, as well as the mediocre response to ultra large stimulus like QEs and minimal interest rates should suffice to prove it.

And I disagree: Because bank regulators should consider the risks that banks are not able to manage the risks they perceive, or that some unexpected events can put the system in danger. But since that has absolutely nothing to do with ex ante perceived risks per se, the capital requirements should be risk-perceived neutral, like for instance solely a leverage ratio. 

Besides, if regulators insist in risk weighing, only to show off some regulatory sophistication, so as to be known as important experts, then they should never forget that what really poses dangers to the banks system is what is perceived safe and never ever what is ex ante perceived very risky.