Even perfectly perceived risks cause wrong decisions if excessively considered

Should banks consider risk factors, such as the probability of default (PD) and the expected loss given a default (LGD), when setting the interest rates it charges clients? Of course, higher perceived risk-higher interests, lower risks-lower interest rates. 

But regulators curiously decided that these risks should also be cleared for in the capital requirements for banks, and decreed: higher perceived risk-higher capital, lower risks-lower capital.

So now banks clear for these risks both with risk adjusted interest rates and risk adjusted capital. That’s a real serious problem because any risk excessively considered, will produce the wrong decision, even if the risk is perfectly perceived.

Now a higher interest rate perfectly set in accordance to a perfectly perceived higher risk translates, because of higher capital requirement, meaning a lower leverage, into a lower risk adjusted expected return on equity. 

Now a lower interest rate perfectly set in accordance to a perfectly perceived lower risk translates, because of a lower capital requirement, meaning a higher leverage, into a higher risk adjusted expected return on equity.

So now banks, even when the risks are perfectly perceived, lend too little to the risky, or in order to compensate for lower ROEs, at too high risk adjusted interest rates; and lend too much to the safe, or thanks to higher ROEs, at too low risk adjusted interest rates.

This is insane! It produces dangerous misallocation of bank credit to the real economy. Too little financing of the "riskier" future and too much refinancing of the "safer" present.

PS. There is still a possibility of credit being allocated efficiently to the real economy, but that requires that what's perceived as safe to be much safer and what’s perceived as risky to be much riskier. What credit rating agencies could guarantee us such mistakes?

Regulators and bankers looking out for the same risks 

Our current bank regulators are dangerous fools.

Bank regulators foolishly allow banks to hold much less capital against assets which are perceived as “safe” than when holding assets perceived as “risky”. 

That means that bank regulators foolishly allow banks to leverage their capital many times more when holding assets which are perceived as “safe” than when holding assets perceived as “risky”. 

And that means that bank regulators foolishly allow banks to earn a much higher expected risk-adjusted return on equity when holding assets perceived as “safe” than when holding assets perceived as “risky”. 

And I say “foolishly” because with that bank regulators introduce a distortion that makes it absolutely impossible for banks to perform their vital social function of allocating resources efficiently. 

And I say “foolishly” because that guarantees that when something ex-ante perceived as safe, ex post turns out to be risky, bank exposures to it will be huge, and the bank capital to cover for it totally insufficient. 

And I hold our current bank regulators to be dangerous fools, because they don´t even understand the harm their capital requirements based on perceived risk of Basel II does to our banking system and that it caused the current crisis; and because they now want to dig us even deeper down into the hole with Basel III adding liquidity requirements which are also based on perceived risk. 

A bank is there to take intelligent risks on behalf of the risk-adverse society, and not to be treated as just another widow or orphan by some dumb overanxious nannies.

A perfect depiction of our bank regulators… looking out in the same direction of bankers for what is perceived as risky, forgetting that in banking, as in so much other, what is really risky is what is considered absolutely safe. (Thanks "Learning from dogs" for the heads up for the photo)