Do the risk weighted bank capital requirements make the risky more or less risky?

Basel III’s bank capital requirement’s risk weights (RW) for residential mortgages depending on Loan to Value (LTV); implied Allowed Leverage of capital/equity (AL) and expected Return On Equity (eROE), calculated with a Risk Adjusted 0.5% expected Return on Asset (eROE) 

LTV<50%: RW = 20%: AL = 62.5 to 1: eROE = 31%

50% < LTV ≤ 60%: RW = 25%: AL = 50 to 1: eROE = 25%

60% < LTV ≤ 80%: RW = 30%: AL = 41.7 to 1:  eROE = 21%

80% < LTV ≤ 90%: RW = 40%: AL 31.25 to 1: eROE = 16%

90% < LTV ≤ 100%: RW = 50%: AL 25 to 1: eROE = 12%

LTV > 100%: RW = 70%: AL 17.9 to 1: eROE = 9%

Those with higher LTV, because they are riskier, must naturally pay banks higher risk adjusted interest rates. But, since banks can hold less capital against lower LTVs, they must also compensate banks, so as to provide these with a competitive risk adjusted return on equity.

So, in order for those who have no money to put down (LTV) > 100%, and with which banks can leverage 17.9 times, in order to compete with those who put down LTV <50%, need to provide an expected Risk Adjusted Return on Asset of 1.73 (31%/17.9); meaning in this case a 1.23% higher interest rate than without this distortion.

And we ask: charging those who have no money to put down, and who should perhaps not even have access to a residential mortgage, a 1.23% higher interest rate than what their risk adjusted interest rate would otherwise be, does that make these more or less risky?

Conclusion: The risk weighted bank capital requirements have, de facto, 0% to do with credit risk reduction, and 100% to do with risk generating distortions.

If race can be correlated to higher LTV mortgages, does this not de facto imply regulators are engaged in discrimination based on race?

Basel Committee... Good Job!

In that real very real class war between those who have houses as investment assets and those who just want affordable homes, where do you stand?

Being more creditworthy should not mean being more worthy of credit

And we must also ask, are the risk weighted bank capital requirements really in accordance with the spirit of the Equal Credit Opportunity Act (ECOA) or the Community Reinvestment Act (CRA)?

The risk weights are to access to credit, what protectionist tariffs are to trade, only more pernicious.

Why has Academia for decades kept silence on Basel Committee’s loony and dangerous risk weighted bank capital requirements?

My 2019 letter to the Financial Stability Board (FSB)

IMF, your main role in supporting social spending, is helping to make sure the resources needed to be spent, are there.

I refer to IMF Policy Paper “A Strategy for IMF Engagement on Social Spending” dated June 2019.

The best strategy for IMF to engage on Social Spending is making sure the real economy, in a sustainable way, provides the most resources to it. That must at this moment begin by loudly protesting the risk weighted capital requirements for banks, something on which the IMF, sadly, has kept silence on for soon three decades.

Since 1988, with the Basel Accord, bank regulations have included, as its pillar, risk weighted capital requirements for banks. The higher the perceived credit risk is, the higher the capital banks need to hold and vice versa, the lower the perceived credit risk is, the lower the capital banks need to hold.

In Basel II of 2004 these risk weights ranged from 0% assigned to AAA to AA rated sovereigns, to 150% assigned to corporates rated below BB-. With a basic capital requirement of 8% that allowed banks to leverage their capital from, an infinite number of times till about 8.3 times.

By doing so that piece of regulation has seriously distorted the allocation of credit, putting both our bank systems at great risk and weakening the possibilities of our real economy to grow in a sustainable balanced way.

We already heard a canary clearly sing in the mine when a crisis exploded because of excessive demand for the securities backed by mortgages to the subprime sector. That demand resulted from that US investment banks and European banks, were allowed to leverage their capital with these securities a mind-boggling 62.5 times, if only a human fallible rating company had assigned it an AAA to AA rating. 

And all that “safe” financing of houses, have only caused these to morph from being homes into being investment assets, at great risk of causing future financial instability. 

And all those “risky” SMEs and entrepreneurs, who used to have their credit needs primarily serviced by banks, are now forced to fish in other less adequate waters. 

And what to say about the 0% risk weighting of all eurozone sovereigns that assume debt denominated in a currency that de facto is not their domestic printable one?

A lower risk weight assigned to the sovereign than to an entrepreneur implies the opinion that a bureaucrat knows better what to do with bank credit, than the entrepreneur who puts his own name to it. If that’s not statism what is? 

In summary: To favor the financing of the ‘safer present’ over the ‘riskier future’ only guarantees the weakening of the economy; and especially large bank crises, because of especially large exposures to what is especially perceived as safe, against especially little capital.

And sadly IMF has kept notorious silence on this.

A letter in Washington Post: Affordable homes or investment assets?

Washington Post: Letters to the Editor December 28

Should houses be affordable homes, or should they be investment assets? They can’t be both.

In 2004, under the Basel II business standards, if securities obtained a AAA rating, European banks and U.S. investment banks regulated by the Securities and Exchange Commission needed to hold only 1.6 percent in capital against them. That created an enormous demand for highly rated securities. The truth of securitization is that, as when making sausages, the worse the ingredients the larger the profits.

And the highly rated securities backed by mortgages to the subprime sector became the primary cause for the 2008 crisis.

After the crisis, ultra-low interest rates and huge liquidity injections fed the price of houses. In the process, houses morphed from being homes into investment assets.

That aspect of the housing market is what I most missed in the Dec. 26 front-page article “Quick to evict, properties in disrepair.”

If you want easy financing to help someone afford a house, then house demand and house prices go up, and you need to give even more help to the next person who wants to afford a house.

Do we want affordable homes or houses as investment assets? There’s no easy answer, because going back to just homes would also cause immense suffering for all those believing they have, with their houses, built up a safety net.

Per Kurowski, Rockville 

PS. “The assets assigned the lowest risk, for which bank capital requirements were therefore low, were those that had the most political support…home mortgages” Paul Volcker 2018

PS. "Lower bank capital requirements against residential mortgages allows easier financing that will cause house prices to increase, and so we bureaucrats can get more in property taxes… and everyone’s happy.”

PS. In the Financial Times, May 2006, I asked: Who on earth has decided that the increase in the price of houses is not inflation?

PS. Here a discussion of this subject with ChatGPT - OpenAI

A tweet: If banks are allowed to leverage their equity/capital twice as much with residential mortgages than with loans to small businesses & entrepreneurs, you will get too many mortgages and too few jobs providing the income to service these. It ain’t science!

A tweet: Economy 101: Allowing banks to leverage capital much more with residential mortgages than with business loans will cause: a) increased house prices, b) decreased job opportunities and, consequentially, more children having to live in their parents’ house.

My letters in the Washington Post on bank regulations:

September 6, 2007: Factors in the Financial Storm
June 20, 2008: An Aspect of the Bubble
December 27, 2009: Another 'worst': Faulty bank regulation
January 6, 2012: Handcuffed by a triple-A rating
May 1, 2013: An American approach to banking
December 23, 2014: Let the market rule on risky trades
November 11, 2015: Reverse-mortgaging the future
August 9, 2016: Banks, regulators and risk
April 16, 2017: When banks play it too safe 
July 11, 2018: There is another tariff war that is being dangerously ignored.