You in Davos, anyone, tell us: How risky to the banking system can a borrower perceived as risky really be?

Regulators require banks to have much more equity against assets perceived as risky, than against assets perceived as safe.

I am totally opposed to that because banks, being able to leverage more, will make higher risk-adjusted returns on when lending to the safe than when lending to the risky. And that causes a dangerous distortion in the allocation of bank credit to the real economy.

But all that is obviously based on that regulators think that those perceived as risky, from a credit point of view, are much more risky to banks than those perceived as safe.

Why? How risky can a borrower perceived as risky really be? Is not the opposite true? That what really poses dangers to the banking system is what is ex ante perceived as absolutely safe, but that ex post might turn out to be very risky?

The risk of any asset to the banking system is a function of the length of the road it can travel from being safe to being risky... and that road is obviously much longer for what is perceived as absolutely safe than for what is perceived as risky.

In the same vein, the purpose of banks can be said to be a function of the length of the road a borrower has to travel from risky to absolute safe... and that road is obviously much longer for what is perceived as risky than for what is perceived as quite safe.

Friends, in Davos you might see some very famous bank regulators walking around. Please do not be intimidated by them. They do not know what they are doing... and if they do, so much the worse.

What would have happened if Basel capital requirements for banks were lower for what’s “risky” than for what’s “safe”?

Many things! Among other:

First, since banks would then not be able to leverage their equity as much as they could with assets perceived as “absolutely safe”, then the risk of traditional bank crises those which result from excessive exposures to what is erroneously perceived as absolutely safe, would of course be lower. And, to top it up, if these were to occur, they would at least find banks covered with much more equity…not standing there bare-naked as now.

Second, the whole procedure of how to game the regulations would change 180 degrees. Instead of having a vested interest in dressing up assets as “absolutely safe”, they would want to dress up assets as “more risky” than they are… and that process would certainly faced more objections, since borrowers and lenders would definitely not share the same objective.

Third, small businesses and entrepreneurs would find it much easier to break that curse described by Mark Twain, of bankers being those who lend you the umbrella when the sun shines and wanting it back as soon as it looks like it is going to rain.

Fourth, it would be harder for too big to fail banks to grow, since low capital requirements hormones are not as effective where it is risky than where it is safe.

Fifth, there would be more “safe” investments available, for you, for me, and for the widows and orphans.

Sadly bank regulators went for an automatic decision: “safe is safe and risky is risky”; and did not take time to deliberate sufficiently on the fact that there where too many empirical evidences that, at least in banking, “risky” was usually safe but that “absolutely safe” could turn into horribly risky.

And here we are… and bank regulators have still not learned that lesson :-(

PS. This is not a proposal... just doing some speculative thinking :-)

The poor, “the risky” and the future are subsidizing the bank borrowings of “the absolutely safe”. Now how about that?

Governments guarantees to help bank creditors if banks fail, which in all essence is a support subsidy to the banks.

And, if banks fail, and government needs to pay up, it is argued that it is the taxpayers who must pay… and we usually leave it at that. 

But, when taxpayers pay, it is actually all who pay, and that means, in relative terms, especially the poor; because the wealthy have more deposits in the banks which are saved; and because the poor would probably be the one most to benefit with the taxes that could be collected, if the support subsidy was not needed to be paid.

But regulators also allow banks to hold less equity when lending to those from a credit point of view perceived as absolutely safe, than when lending to those perceived as risky; and that signifies that the support subsidy is effectively bigger for those perceived as absolutely safe than for those perceived as risky.

Finally, what has already made it, namely the history, has a lot more possibilities of being perceived as absolutely safe, than what needs an opportunity to be, namely the future.

All that translates into that the poor, those perceived as "risky" and the future, are subsidizing the bank borrowings of the “absolutely safe”… now how about that? And, if that is not a cruel way of fostering inequality, what is?

Who is Mark Carney to talk about providing equal opportunity to all citizens?

We read Mark Carney the governor of the Bank of England saying “there is growing evidence that relative equality is good for growth. At a minimum, few would disagree that a society that provides opportunity to all of its citizens is more likely to thrive than one which favours an elite, however defined”

Who is he to talk about this? As a chairman of the Financial Stability Board, Mark Carney has approved for years risk-weighted capital requirements for banks, which discriminate against bank lending to “the risky”, those already discriminated against, precisely because they are perceived as “risky”, and favors bank lending to the “absolutely safe”, those already favored, precisely because they are perceived as “absolutely safe”.

How come XXX, who graduated as a financial expert from YYY, did not know this?

Anyone with some basic financial knowledge must know that banks allocate their portfolio to what produces them the highest risk-adjusted return on their equity; and that constitutes in its turn the best possible (or least bad) way of allocating bank resources to the real economy.

What I cannot for my life figure out is how come a financial professional does not understand that if bank regulators allow banks to hold much less shareholder’s capital against some assets, for instance those perceived as “safe”, than against other assets, for instance those perceived as “risky”, then the banks will earn higher risk adjusted returns on “safe” assets than on “risky” assets, which will distort the allocation of bank credit, and guarantee that the banks will hold too much “safe” assets and too little “risky” assets.

And of course when banks hold “too much” of a “safe” asset, then that asset could turn into a very risky asset for the banks. This is by the way something empirically well established. Never ever has a major bank crisis resulted from excessive exposures to what was perceived ex ante as “risky”, these have all, no exceptions, resulted from excessive exposures to what was ex ante, erroneously perceived as safe... like AAA-rated securities, Greece, etc.

And of course holding “too little” of the “risky” assets, like of loans to medium and small businesses, entrepreneurs and start ups, is very bad for the real economy which thrives on risk-taking, and is therefore, in the medium term, something also very risky for the banks.

How come all those reputable tenured finance professors in so reputable universities did not care one iota about the allocation of bank credit in the real economy was being so completely distorted by the risk-weighted capital requirements for banks? 

Anything you distort I can distort better, I can distort anything better than you. Yes I can, yes I can, yes I can!

So sings the Basel Committee for Banking Supervision and the Financial Stability Board, while proceeding to distort all common sense out of how banks allocate credit in our real economy.

For this they concocted capital requirements based on the same ex ante perceived risks which were already being cleared for by the market.

And with this they made banks earn much much higher expected risk adjusted returns on equity on assets perceived as “absolutely safe” than on assets perceived as “risky”.

And with that they caused banks not to finance the risky future but only refinance the safer past.

And all for nothing, because that only doom banks to end up gasping for oxygen in dangerously overcrowded “absolutely safe havens”.

If they young would just look up from their iPads for a second, and understand what is being done to them, I would not like to be in the Great Distorters' shoes.

But she knew how to aim!

A regulator´s risk is totally different from a banker´s risk... and current bank regulators do not know this. God save us!

A banker has to believe he has appreciated the risks of assets and borrowers correctly, and covered for these adequately, in order to do his banking business. 

A bank regulator´s risk on the other hand, has nothing to do with the intrinsic risks of bank assets or borrowers, and all to do with whether the banker has been correct or not, in his appreciations of the risks, and if he has adjusted adequately his exposures to it.

And that is why it is so extremely silly of bank regulators to risk-weigh the capital requirements for banks based on the ex ante perceived risk of assets and borrowers, instead of setting a sufficient capital requirement to cover reasonably for the bankers committing mistakes.

And, if trying to do so, the regulator would very soon be able to understand that the assets or borrowers that really signify major dangers for the banks, are those assets that, when booked, were considered “absolutely safe”.

In other words, if risk-weighting, not for the bankers´ risks but for the regulators' risk, the capital requirements for what is perceived as “absolutely safe” should be higher than for what is perceived as “risky”.

And so currently bank regulators are with their risk weights not only distorting the allocation of bank credit to the real economy but, on top of it all, they are doing it in the totally wrong direction. God save us!