It behooves us to revise the purposes of our banks, as these are defined by current capital requirements

The lower a capital requirement is, the higher can a bank leverage its equity, the higher is the risk adjusted return on equity it can obtain.

Risk weights of: sovereign 0%, AAA rated 20%, residential housing 35% and unrated SMEs 100%, clearly indicate that the de facto purpose regulators have imposed on banks, is to finance sovereigns, those who already enjoy the lowest risk-premiums, and those buying houses and therefore implicitly house prices. 

Regulators have told us this is so that our banks are made safe. Silly! Our bank systems are never threatened by “risky” SMEs and entrepreneurs, only by that perceived ex ante as very safe and that ex post turns out to be very risky. 

I would expect much more from our banks, like financing development, sustainability and job creation; and I would assume many would agree with me.

If we want that produced by banks, by means of allocating credit as efficiently as possible to the real economy, then we should make sure every single bank asset, except for cash, generates exactly the same capital requirement.

Now if regulators absolutely insist on nudging, so to be perceived as earning their pay, then perhaps they could base their capital requirements on how the asset helps to finance development, sustainability and job creation.

And, if regulators want to be really sophisticated about it, then the could even fill each box of a purpose/credit risk matrix with individual capital requirements… always of course remembering the golden rule of the riskier it seems ex ante the safer it is ex post. 

PS. Perhaps the capital requirements could even be slightly based on gender, so as to give women some compensation for all the disadvantages we are told they suffer. (Psst some tell me that loans to women also carry less risk)

Prioritizing the financing of residential property over the financing of job creation is not the smartest thing to do

Based on Basel II’s standard capital requirements for banks, these are required to hold 2.8 percent in capital when lending secured by mortgages on residential property and 8 percent when lending to SMEs and entrepreneurs. 

That means that the adjusted for risk net margin paid by a residential borrower can be leveraged 35 times by the bank (100/2.8), while the same margin can only be leveraged 12.5 times (100/8) if paid by SMEs and entrepreneurs.

And that means banks can obtain much higher risk-adjusted returns on equity when lending secured by mortgages on residential property than when lending to SMEs and entrepreneurs. 

And that means that banks will find it much more interesting to finance residential property than to finance those who can help to create the jobs to help residential mortgages and utilities to be serviced.  

That definitely sound skewed the wrong way. If I was the regulator I would much rather prefer banks financing more the creation of jobs, so that people could better afford to buy their homes with less financing… but that’s just little me.

“But building homes creates jobs?” Indeed, but once everyone has a home, and a mortgage to service, which diminishes their available income, where are our grandchildren to work?