Basel III, risk based capital requirements, leverage ratio, distortions, and “The Drowning Pool”

I have for years seriously criticized the distortions in the allocation of bank credit to the real economy that the risk based capital requirements of Basel II produce. And now I am often being answered that these distortions have been in much removed because of the introduction in Basel III of the 3 percent leverage ratio, that which is applied on all assets without any risk weighing.

Unfortunately the truth is that could make the distortions even worse, and equally unfortunate, the why of it, is not so easy to explain… and so here I give it another go.

Have you seen “The Drowning Pool”, where Paul Newman and Gail Strickland are locked in a hydrotherapy room, with the water rising to the ceiling? Well think of the capital requirements as the hydrotherapy room, and the leverage ratio as the water level. 

In Basel II, there was more room-oxygen for banks to maneuver around the risk-weights but, in Basel III, by means of the water level having risen, there is now less room-oxygen for the banks to breathe… and so the more the distortion.

And so Basel III by making the search for breathing space harder will therefore make banks even more loath to give credit to “the risky” those which regulators decided consume more oxygen-capital. Get it?

And of course that is not helped by the fact that, with the introduction of liquidity requirements which is also based on ex ante perceptions of risks, new sources of distortion are being introduced.