Wednesday, June 4, 2014

Here for discussion is an alternative, less distorting, risk-weighted bank capital requirement regulation.

I have for more than a decade strongly opposed the Basel Committee’s risk-weighted capital requirements for banks. 

This primarily because these seriously distort the allocation of bank credit in the real economy, but also because they make little empirical sense, since what historically have caused all major bank crises, are not big bank exposures to what ex ante is considered risky, but always too large exposures to what was erroneously perceived ex ante as absolutely safe.

But since it seems that regulators do not feel they are doing their job if they don’t do risks weighting, my criticism has not been sufficiently considered.

In that respect let me here briefly express a simple alternative of risk-weighing the capital of a bank.

Though it would not increase the ultimate long term safety of the banks, because of the fundamental regulatory mistake of confusing ex-post risks with ex-ante perceptions, it could at least produce much less distortion in the allocation of bank credit.

1. Calculate the risk-weighted size of the bank’s balance sheet. 

2. Divide that number by the gross balance sheet of the bank. 

3. Multiply the resulting ratio times a basic capital requirement, for instance Basel II’s 8 percent.

4. Make the resulting percentage the general capital requirement for that bank in particular and to be applied to all its assets.

5. Make a medium term plan on how to increase that percentage for that particular banks, to for instance Basel II's 8 percent.