Mr Mario Draghi. For Europe’s good, why not take a sabbatical year and do all it takes for you to understand the RWCR?

The citations below are extracted from the speech “Cross-border markets and common governance” delivered by Mario Draghi, President of the ECB, during the Bank of England Open Forum, London, 11 November 2015.

These evidence that the former Chair of the Financial Stability Board, does yet not understand what caused the current crisis, namely the distortion in banks assets allocation to the real economy produced of Basel II’s risk weighted capital requirements for banks (RWCR); more ex ante perceived risk, more capital – less risk, less capital.

Draghi: “To reap the benefits of openness, markets require appropriate governance. Indeed, a market stipulates not just the freedom to take part in the market, but also the means to protect that freedom. That means the confidence that contracts entered into will be enforced. It means the assurance that the rules of fair competition will be upheld, that property rights will be respected, that standards and codes will be applied properly. It means, in short, the Rule of Law.”

Mr. Draghi: The RWCR violated directly the rules of fair competition in the markets for bank credits. These allow banks to earn higher risk adjusted returns on equity on assets perceived as safe than on assets perceived as risky. As a consequence those perceived as safe and who already pay lower interest rates and have access to more bank credit are, because of the RWCR, treated even better, in direct detriment to the fair access to bank credit of those perceived as risky. And negating the risky fair access to bank credit is a prime inequality driver. 

Draghi: “For financial markets this is especially important given their inherent fragility. If rules and standards are not effectively applied, it can produce information asymmetries and other destabilising forces which, in turn, lead to sudden reversals of confidence in the market. We have seen in the past how markets have run ahead of regulation leaving them vulnerable to such dynamics.”

Mr. Draghi: Those RWCR produced gigantic information asymmetries and destabilising forces. Go back and read all the specialized newspaper that spoke of well capitalized banks, like of a 10 to 1 leverage, without understanding that this was based on risk-weighted assets and that their real leverage was often 50 to 1.

Draghi: “Here is one illustration: during the crisis, the market for securitised assets was all but destroyed by a collapse of confidence. Lack of oversight allowed excesses to be committed and market abuse to take place” 

Mr. Draghi. The fact that Basel II of June 2004 allowed banks to hold those securities against only 1.6 percent in capital if they achieved an AAA to AA rating; which means an almost unimaginable allowed leverage of 62.5 to 1, provided the incentives for excesses and market abuse to be committed. Before that there had been mortgages to the subprime sector for many decades, without these causing any problems.

Draghi: “Securities that were previously deemed safe, certainly with some measure of complacency and too much blind confidence, turned out to be very unsafe indeed, and imparted significant losses on their holders.”

Mr. Draghi: Securities or loans "that were previously [ex ante] deemed safe, certainly with some measure of complacency and too much blind confidence, and turn out [ex post] to be very unsafe” is precisely the stuff all major bank crises in history are made of. Show us one bank asset that was perceived as risky when it was placed on the balance sheets and that amounted to such an importance that it caused a major bank crisis? There is none! 

Draghi: “What is also unfortunate is that the subsequent attempts to re-regulate that market have threatened to undermine the parts that are beneficial to many. There was too much opacity as to the nature of the assets underpinning asset-backed securities, too damaging a breakdown of confidence in the integrity of those who packaged and sold them. And the immediate temptation of regulators was to impose punishing capital charges on holdings of asset-backed securities, independent of their individual characteristics, mixing the wheat with the chaff.”

Mr. Draghi. Regulators should not substitute for the markets. Let the market value the individual characteristics of the wheat and the chaff. At this moment all the stimulus to the economy are being dangerously wasted because regulators have decided, with their risk weights to treat the “risky” SMEs and entrepreneurs as chaff, and not as the nutrient and for the economy indispensable wheat they represent. 

Mr. Draghi the capital of banks is to cover for unexpected losses, and that is something explicitly accepted by the regulators. And so here follows some basics in risk management you and your colleagues could benefit from knowing:

It does not make any sense setting what is to cover for the unexpected based on expected credit losses already cleared for.

The RWCR doubled up on credit risk; and any risk, even if perfectly perceived, results in the wrong actions if excessively considered.

The regulators concerned themselves with the risks of bank assets while their worry should have exclusively been on how banks manage the risks of those assets.

You allowed big banks to decide on the capital required by using risk models. That was like telling your kids they can pick anything they want from a menu of ice-cream chocolate cake, spinach and broccoli. Is that a market?

The safer something is perceived the greater its potential to deliver unexpected losses.

Motorcycles are riskier than cars, but car accidents cause more deaths than motorcycle accidents.

It is not by telling banks to avoid risks that we can live up to that holy intergenerational bond Edmund Burke spoke of.

Mr Mario Draghi. For the good of Europe, why do you not take a sabbatical year to reflect on this? You said you were willing to do all it takes.

Hopefully Mr Draghi you would end up understanding that the biggest systemic risks for banks are always imbedded in the assets perceived as the safest or so safe that all must have them; and that excessive risk aversion is about the riskiest there is for the economy...