Friday, March 22, 2013

Basel Committee, stop giving our banks your capital requirements suppositories.

Banks, before the Basel era, cleared for perceived risk, that which for instance is to be found in credit ratings, by taking caplets containing the interest rate (risk-premiums), the size of the exposure and other contractual terms. 

But Basel II, and now Basel III, ordered the banks to also clear for exactly the same perceived risk, credit ratings, by means of a suppositories containing capital requirements, more risk more capital, less risk less capital. 

That double dosage against “perceived risk” allow banks to leverage many times more their equity when lending to what is perceived as “safe” than when lending to what is perceived as “risky”, and that allows the banks a much higher expected risk-adjusted return on equity when lending to “The Infallible” than when lending to “The Risky”. 

And that distorts and makes it impossible for banks to allocate economic resources efficiently.