What would have happened if, since Basel I, 1988, there had just been one 8% bank capital requirement for all assets?

The “safe” sovereigns would not have seen their borrowings subsidized by the “risky” SMEs and entrepreneurs lesser access to bank credit. 

Sovereigns like Greece would never have been able to run up such large debts on such low initial interest rates.

House financing would not have been so much available at artificial low rates so house prices would be lower.

Much more financing would have gone to those “risky” SMEs and entrepreneurs who could create the jobs the house owners need in order to repay mortgages and service utilities, and that so many young need in order not having to live in the basements of their parents’ houses.

Some other crisis could have resulted, but the catastrophic sized one with the AAA rated securities collateralized with mortgages to the subprime sector, would never have happened.

Central banks would not have needed to kick the crisis can down the road with trillions of QEs… that are still out there on the road menacing to run back on us.

Central banks would not have needed to kick the crisis can down the road with ultra low interest rates that are creating havoc on all pension plans.

The world would not have served up the table with so much for the populists to munch on.

The saddest part though is that now, ten years after those assets that caused the big crisis correlated completely with those assets that required banks to hold the least capital, regulators still apply risk weighted capital requirements. I guess, as Upton Sinclair Jr. said, “it is difficult to get a man to understand something when his salary depends upon his not understanding it.”

Even perfectly perceived risks cause wrong decisions if excessively considered

Should banks consider risk factors, such as the probability of default (PD) and the expected loss given a default (LGD), when setting the interest rates it charges clients? Of course, higher perceived risk-higher interests, lower risks-lower interest rates. 

But regulators curiously decided that these risks should also be cleared for in the capital requirements for banks, and decreed: higher perceived risk-higher capital, lower risks-lower capital.

So now banks clear for these risks both with risk adjusted interest rates and risk adjusted capital. That’s a real serious problem because any risk excessively considered, will produce the wrong decision, even if the risk is perfectly perceived.

Now a higher interest rate perfectly set in accordance to a perfectly perceived higher risk translates, because of higher capital requirement, meaning a lower leverage, into a lower risk adjusted expected return on equity. 

Now a lower interest rate perfectly set in accordance to a perfectly perceived lower risk translates, because of a lower capital requirement, meaning a higher leverage, into a higher risk adjusted expected return on equity.

So now banks, even when the risks are perfectly perceived, lend too little to the risky, or in order to compensate for lower ROEs, at too high risk adjusted interest rates; and lend too much to the safe, or thanks to higher ROEs, at too low risk adjusted interest rates.

This is insane! It produces dangerous misallocation of bank credit to the real economy. Too little financing of the "riskier" future and too much refinancing of the "safer" present.

PS. There is still a possibility of credit being allocated efficiently to the real economy, but that requires that what's perceived as safe to be much safer and what’s perceived as risky to be much riskier. What credit rating agencies could guarantee us such mistakes?

Regulators and bankers looking out for the same risks 

10 years after, the problem is not that some are forgetting bank regulations, but that most never learned about these.

1. Allowing banks to leverage their equity more with The Safe, like with Sovereigns and AAA rated, than with The Risky, like with SMEs, allows banks to earn higher risk-adjusted returns on their equity with The Safe than with The Risky. 

2. That distorts the allocation of bank credit to the real economy causing banks to lend too much to The Safe and too little to The Risky.

3. And all for nothing because all major bank crisis have resulted from excessive exposures to what was perceived as belonging to The Safe, and never ever from exposures to something perceived as belonging to The Risky when placed on bank's balance sheets. 

Since risk weighted capital requirements for banks are still used, we are still on the same route to new similar failures.

 

Here is much more on this

Nothing could be so dangerous as big data wrongly interpreted and manipulated

Regulators gathered data on credit risks and developed their risk weighted capital requirements for banks… more risk, more capital – less risk less capital.

But the data they were looking at was the ex-ante perceived credit risks, and not the ex-post possible risks after the ex-ante risks had been cleared for.

And therefore they never realized that what is most dangerous for the banking system is what is perceived very safe and could therefore create large exposures; while what is perceived as very risky is by that fact alone, made innocuous for the banking system

And as a consequence we have already suffered a big crisis because of excessive exposures to AAA rated securities backed with mortgages to the subprime sector; and millions of those risky young dreaming of an opportunity of a bank credit to prosper, have had to give up their dreams or pay higher interest rates that made them even riskier. 

So friends, always prefer well interpreted and well manipulated small data over mishandled big data.