What is so mindboggling absent from Martin Wolf’s book “The shifts and the shocks”

If there is one thing that explains the origin of the current financial crisis and the main reason why we do not seem to find our way out of it, that has to be the crazy credit risk-weighted capital requirements for banks, approved as Basel II, in June 2004.

These risk weighs instructed banks to have different amounts of capital for based on the ex ante perceived credit risks of assets, with weights fluctuating from zero to 150 per cent.

As the basic capital requirement in Basel II was 8 percent this indicated capital (meaning equity) requirements that ranged from zero percent to 12 percent, which translates into different allowed equity leverages that range from infinite to till 8.33 to 1.

For instance:

A bank lending to an AAA to AA rated sovereign needed to hold no equity at all, implying an infinite allowed leverage.

A bank investing in a private AAA rated asset needed to hold only 1.6 in equity, indicating an allowed leverage of 62.5 to 1.

A bank lending to an unrated private needed to hold 8 per cent in equity, indicating a 12.5 to 1 allowed leverage, and

A bank lending to a below BB- rated client could only do so against 12 per cent in equity, which implied and allowed leverage of only 8.3 to 1.

And of course that distorted all economic sense out of the banks’ allocation of credit to the real economy.

And if there is one document one needs to read in order to understand what these risk weights were all about that is of course the “Explanatory Note on the Basel II IRB Risk-Weight Functions” issued by the Basel Committee in July 2005.

Well, Martin Wolf, in his book “The shifts and the shocks – What we’ve learned-and have still to learn-from the financial crisis”, references 526 documents or sources but does, amazingly, mind-boggling, not include this document.

Either he does not know of it, or he does not understand it and dares not to say so. You choose.

If the latter he should not be too nervous… it is an amazing mumbo jumbo.