What to do when even describing it, an eminence like Martin Wolf is yet unable to see The Great Bank Distortion?

On page 251 of his “The shifts and the shocks” Martin Wolf writes: 

“But [bank] shareholders should only be interested in their risk adjusted returns. If taking on more risk does not raise risk-adjusted returns, shareholders should flee.”

But let me now give you the fuller version of what he writes:

So: "If taking on more risk [like lending to small businesses and entrepreneurs] “does not raise risk-adjusted returns, [because when doing so bank regulators require banks to hold more equity] “shareholders should flee”.

The result: No bank credit to “risky” small businesses and entrepreneurs.

And the other side of the coin would be: "If taking on less risk, like lending to the infallible sovereigns, the housing sector or to members of the AAAristocracy, does raise risk-adjusted returns, because when doing so bank regulators allow banks to hold much less equity, shareholders will love it.

The result: Too much bank credit to the infallible sovereigns, the housing sector and members of the AAAristocracy.

And Martin Wolf, on page 243 concludes that: “Risk-weighted assets can play a secondary role. That way one would have a ‘belt and braces’ approach: a strong leverage ratio, plus a risk–weighted capital ratio as a back-up.

And that he does because on page 251 he argues: “Risk-weighting is extremely unreliable, because the samples from which the weights are derived are always too small or irrelevant”. 

Wolf simply does not understand the dangerous distortion produced by risk weighting... even if the risk-weights are perfect. If perfect they would be perfectly cleared for in the interest rates, the size of bank exposures and all other contractual terms. To also clear for these perfect risk-weights in the capital, signifying a double counting of the perfect risk weights, is just sheer regulatory lunacy. 

“A ship in harbor is safe, but that is not what ships are for”, wrote John Augustus Shedd (1850-1926),.And that goes for our banks too.

And precisely because we all want our ships, or our banks, to sail as safe as possible to the ports we want them to sail to… the last think we should do… is what bank regulators, thinking themselves with 'fatal conceit' capable of being risk managers to the world did… namely to start tinkering with risk weights with their compasses. 

And so no Martin Wolf, not even as a back-up is there a role for credit risk weighted bank capital.

And if we really get down to what Wolf writes on page 252: "the disaster came from what banks wrongly thought to be safe", and which by the way is what all empirical evidence would point at as the usual suspect of causing bank disasters, then the capital requirements should be totally opposite; larger for what is perceived as absolutely safe and lower for what is perceived as risky.

In short, the number one "Macro-prudential Policy" that needs to be implemented, is to get rid of the current batch of distorting bank regulators. But, for that to happen, it is helpful that eminences, like Martin Wolf, also understands what is going on.