Here a simple as can be one-minute explanation of the distortions produced by the risk weighted bank capital requirements in the allocation of credit to the real economy.
For 600 years, before the Basel Accord of 1988, banks, with an eye to their overall portfolio, allocated their assets depending on the perceived risk adjusted return these were to produce.
For instance if a safe asset at a 4% interest rate and a risky asset a 7% interest were both producing a 1% net risk adjusted return acceptable to the banks, they could pick either one or both. If banks were allowed (by markets or regulators) to leverage their assets 10 times, that would produce them a 10% risk adjusted return on equity.
But the introduction of the risk weighted bank capital requirements changed all that.
Let us suppose that banks were now allowed to leverage 30 times their equity with safe assets but still only 10 times with risky assets.
That with the previous numbers though risky assets would still produce a 10% risk adjusted return on equity, the safe assets now delivered 30%.
And so either the risky had to be charged 9% instead of 7%, so as to deliver the 3% risk adjusted return that, with a 10 times allowed leverage would earn banks a 30% risk adjusted return on equity, something that naturally made the risky even riskier; or the safe could be charged a 2% interest rate instead of 4%, and still deliver a 10% risk adjusted return on equity.
What happened? The risky, like unsecured loans to entrepreneurs, were abandoned by banks, while the safe, like sovereigns, residential mortgages and AAA rated, were much more embraced by banks, who even offered these lower interest rates than in the past.
And the risk-free rate became a subsidized risk-free rate.
“A ship in harbor is safe, but that is not what ships are for.” John A. Shedd. But the Basel Committee for Banking Supervision is causing banks to dangerously overpopulate safe harbors, while leaving the riskier oceans to other investors and small time savers.
And the savvy loan officers were substituted by creative bank equity minimizing financial engineers
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