Fed Chair Janet Yellen has not been briefed on the real implications of current risk-weighted capital requirements for banks.

I refer to Fed Chair Janet L. Yellen speech At the 2014 Michel Camdessus Central Banking Lecture, International Monetary Fund, Washington, D.C. July 2, 2014 on Monetary Policy and Financial Stability.

From it I deduct that she has not yet been fully briefed about the real implications of the pillar of current bank regulations namely the risk-weighted capital requirements for banks.

I will illustrate this with two examples:

First Yellen states: “A smoothly operating financial system promotes the efficient allocation of saving and investment, facilitating economic growth and employment. A strong labor market contributes to healthy household and business balance sheets, thereby contributing to financial stability. And price stability contributes not only to the efficient allocation of resources in the real economy, but also to reduced uncertainty and efficient pricing in financial markets, which in turn supports financial stability.”

Absolutely, the problem though is that by means of risk-weighing the capital banks are required to hold, you allow banks to earn different risk-adjusted returns on equity something which stops in the tracks any possibility of efficiently allocating bank credit in ways that permit sturdy economic growth. In essence current requirements, by allowing banks to earn more on the “absolutely safe” it has stopped banks to lend sufficiently to the risky, like medium and small businesses, entrepreneurs and start-ups. And, an economy with insufficient risk-taking, is doomed to recede.

But also, from the perspective of financial stability the current risk weights are completely wrong, since never ever do big bank crises erupt from too much bank exposure to what is ex ante considered risky, they always result from too much bank exposures to what ex ante is considered absolutely safe, but that ex post turns out very risky.

Second Yellen states: “Tools that build resilience aim to make the financial system better able to withstand unexpected adverse developments. For example, requirements to hold sufficient loss-absorbing capital make financial institutions more resilient in the face of unexpected losses.”

Absolutely, the problem though is that the current risk weights have nothing to do with unexpected losses, and all to do with the expected losses derived from the perceived credit risks which are already cleared for in interest rates, size of exposures and other contractual terms.

And the consequence of that is that expected losses get cleared for twice, while the unexpected losses are not considered, and huge distortions ensue.

In the remote possibility that Janet Yellen would read this, let me end here by assuring her that if banks had had to hold the same capital against any asset, for instance the basic Basel II's 8 percent, something else might have happened… but not the current crisis.

PS. Here is a link to a fuller list of the Basel II mistakes.