ECB’s Sabine Lautenschläger explains why the risk weighted capital requirements for banks is total lunacy but, unfortunately, not even she hears it.

I quote the following from ECB’s Sabine Lautenschläger’s speech on February 15, 2018, “A stable financial system – more than the sum of its parts” 

“Logic can be a tricky thing. Apply it in the right way, and you always arrive at a consistent conclusion. But apply it in the wrong way, and it can lead you astray. And that happens all too easily. There are indeed many wrong ways in which we can apply logic.”

One of them is known as the fallacy of composition. It refers to the idea that the whole always equals the sum of its parts. Well, that idea is wrong. As we all know, the whole can be more than the sum of its parts – or less.

Consider this statement: if each bank is safe and sound, the banking system must be safe and sound as well. By now, we have learnt the hard way that this might indeed be a fallacy of composition.

Let me give you just one example. Imagine that a certain asset suddenly becomes more risky. Each bank that holds this asset might react prudently by selling it. However, if many banks react that way, they will drive down the price of the asset. This will amplify the initial shock, might affect other assets, and a full-blown crisis might result. Each bank has behaved prudently, but their collective behaviour has led to a crisis.

The business of banking is ripe with externalities, with potential herding and with contagion. These factors may not be visible when looking at individual banks, but they can threaten the stability of the entire system. This is one of the core insights from the financial crisis.”

Let me comment on the implications of this quite lengthy quotation: 

First: “a certain asset suddenly becomes more risky” That means that the real problem is that it was perceived as safer before.

Second: “The business of banking is ripe with externalities, with potential herding and with contagion.” There can be no doubt that potential herding” is much mote likely to occur with assets perceived as safe.

So what is Sabine Lautenschläger really saying with all this? That the current risk weighted capital requirements, Pillar 1, more perceived risk more capital – less perceived risk less capital, is sheer lunacy, though she might not understand it. 

The truth is that the real logic, not that pseudo logic applied by bank regulators, is that the safer an asset is perceived, the greater the potential danger to the bank system it poses.

Lautenschläger also said: “Imagine that there is a downturn in the financial cycle. From the viewpoint of each bank, credit risks increase and microprudential supervisors may want to increase Pillar 2 capital demands. Looking at the same trend, macroprudential supervisors might want to support credit growth and counter the cycle over a longer time horizon and from a systemic point of view. Thus, they may want to decrease Pillar 2 capital demands.”

“credit risks increase” That goes in the direction from safer to riskier. Does going from riskier to safer pose any danger? No!

So is not assigning the lowest capital requirements to what is ex ante perceived as safe just the mother of procyclical regulations, or in other words, the mother of all macroprudential imprudences? 

Ex post dangers are a function of ex ante perceptions. The safer something is perceived the more real danger it poses. The riskier something is perceived, the less harm it can cause.

How on earth could one expect a good application of Basel Committee’s Pillar 2 (Supervisory Review Process) from those who are messing it all up with a so faulty Pillar 1?

Recommendation: Ask a regulator: “What is more dangerous to the bank system, that which is perceived risky or what is perceived safe?” If he answers, the “risky”, ban him from regulating banks.