The Basel II Roulette Manipulation
Because of what they perceive as reckless speculative risk-taking by banks, many refer to banking as a casino. So, let us think of the different loans and investments a bank can make, in other words of their allocation of bank credit to the economy, as their alternative bets on a roulette table.
On such table there are e.g., “Safe Bets”, black or red, with a payout of 1 plus the bet; “Intermediate bets”, columns, with a payout of 2 plus the bet; and “Risky Bets”, any single number, with a payout of 35 plus the bet. All bets have of course a similar expected value of return, the same risk-adjusted return. In the case of the roulette, a somewhat negative one, because the House always wins when the zero or double zero comes up, the House Edge. In banking, good credit and investment analysis, is expected to provide positive yields, even for the "zero" and "double zero".
Imagine then that a Basel Committee for Roulette Supervision suddenly got concerned with that some players were making too many risky plays; losing all their money, very fast, and that this was something for which they, as a regulatory authority, could be blamed for, and decided to do something about it.
And so, they decreed their Basel Roulette Regulations by which, in order to keep the players playing longer and not losing it all so fast, they allowed the payout for “Safe Bets” to be five times higher, 5 plus the bet; the payout for “Intermediate Bets” double the current, 4 plus the bet; while the payout for “Risky Bets” would remain the same, 35 plus the bet.
What do you think would happen? Just what had to happen! Every player ran to make “Safe Bets”, and now and again, just for kicks, perhaps an “Intermediate Bet”, but they all stayed away from “Risky Bets”, since these just did not any longer make sense.
And the players got so excited with their profits, and bet more than ever, and so when suddenly the zero or double zero appeared, as had to happen, sooner or later, they lost fortunes and got wiped out, more than ever, often to such an extent that the casino even had to pay for their taxi ride home. Of course casinos, as we know them, could no longer exist.
Before current Basel bank regulations, all bank lending or investment alternatives produced basically the same expected risk and cost of transaction adjusted returns on equity; because that is what a free competitive market and banking mostly produces. This was precisely what The Basel Committee for Banking Supervision changed when, with Basel II, it imposed different risk-weights to determine the banks shareholder's capital/equity/skin-in-the-game requirements for different assets.
For instance, against any AAA to AA rated asset, “The Infallible”, banks had to hold only 1.6 percent in shareholders’ capital/equity/skin-in-the-game, and were therefore allowed to leverage their equity with the net risk adjusted interest rate 62.5 times to 1. Against “The Risky” assets, like loans to unrated small businesses and entrepreneurs, banks must hold 8 percent in capital meaning they then can “only” leverage their equity 12.5 times to 1. For “The Intermediate” assets, with a 4 percent capital requirement, in a similar way a 25 to 1 leverage is authorized.
The result? When compared to the allowed leverage on equity of the net risk adjusted interest rate, the payout/ROE for “The Risky”, translates into a FIVE times higher allowed payout/ROE for “The Infallible”, and TWO times higher for “The Intermediate”.
This absolutely loony manipulation of the odds of banking; and which obviously not only guaranteed that when disaster struck the banks would be standing there naked without any capital; also made it impossible for the banks to perform with any sort of efficiency their vital role of allocating economic resources.
And the craziest thing is that soon five years after the 2008 GFC disaster occurred, this manipulation of the odds of banking is not even being discussed. Not even against clear evidence that, as usual, as these always are, this crisis was the result of banks building up excessive exposures to what’s perceived or decreed as safe, in this case AAA to AA rated securities backed with mortgages to USA’s subprime sector.
Poor us! These banking regulations are castrating our banks, making them sing in falsetto accumulating more balance sheets exposure to the "safe-havens", which will become dangerously overpopulated; while avoiding like the plague exposures to the riskier but probably more productive bays where our young could find the next generation of jobs they so urgently need.
PS. The distortion had already begun in 1988 with Basel I: “The assets assigned the lowest risk, for which bank capital requirements were therefore low or nonexistent, were those that had the most political support: sovereign credits and home mortgages” Paul Volcker
PS. And it would be so comic, if not so tragic, that absolutely most experts, including Nobel Prize winners, keep on referring to the crisis as a result of excessive risk-taking by banks, and which is of little assistance when trying to explain that what all banks were doing, was betting excessively on boring safe bets, red or black, and this only because of bad regulations… rien ne va plus.
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