Tuesday, July 1, 2014

My list of the biggest X mistakes of risk-weighted capital requirements for banks, which regulators (and FT) ignores

For the time being, and in no particular order… 

1. The risk-weights are portfolio invariant, which means these do not reflect the dangers of excessive concentration or the benefits of diversification. The main explanation for the why of this is, amazingly, that otherwise it would have been too difficult for regulators to manage.

2. The risk-weights are based on the expected risk which is already being cleared for by bankers, by means of interest rates, size of exposure and other contractual terms; and not based on the unexpected risks, that which should really be the concern of regulators.

3. The risk-weights with their consequential different capital requirements for different assets allow banks to earn higher risk-adjusted returns on its equity on assets classified as "safe" than on assets deemed "risky", something which hugely distorts the allocation of bank credit in the real economy.

4. One thing is the risk for the banks of the expected risks of their assets… and another completely different the risk for regulators of the banks not perceiving the expected risk correctly.

5. The less the number of those officially appointed to perceive credit risks, like the human fallible credit rating agencies, the larger the consequences of a magnificent risk-perception imperfection.

6. The only reason for which regulators can set higher capital requirements for banks when lending to “the infallible” than when lending to “the risky” is that they did not do any empirical research on what always causes bank crises, namely excessive exposures to something ex-ante considered "absolutely safe" but that ex-post turned out not to be.

7. To believe that the risks of huge loans to an infallible sovereign are greater than many small loans to that sovereigns subjects, is about as crazy as it gets… unless of course you are a communist.

8. Emphasizing the avoidance of short term perceived credit risks, without considering the benefit that loans to "the risky" might bring to the sturdiness of the real economy, causes banks to concentrate on financing the safer past and to avoid financing the riskier future… which is something our children will pay dearly for.

9. Ridiculously small capital requirements, 4%, 2.8%, 1.6% and even 0% constitute of course the best growth-hormones for the “too-big-to-fail” banks.

10. Diminishing the importance of bank capital allows for outrageous bankers’ bonuses.

11. Of course underlying all of the problems of Basel II is that there is not a word to be found in all the Basel Committee’s regulations about what is the real purpose of the banks. No wonder!

12. To ignore the consequences of all the distortions in the allocation of credit to the real economy the risk-weighing has and will cause, is sheer lunacy!

PS. This post will be continuously revised.

Basel Committee for Banking Supervision and the Financial Stability Board take notice: Anyone who imposes regulations that can be gamed is the wrongdoer’s best friend