Paul Volcker valiantly accepted that the risk weighted bank capital requirements he had helped to promote had serious problems.
In his 2018 autobiography “Keeping at It” Paul Volcker wrote:
“The US practice had been to assess capital requirements by using a simple “leverage” ratio-in other words, the bank’s total assets compared with the margin of capital available to absorb any losses on those assets. (Historically, before the 1931 banking collapse, a 10 percent ratio was considered normal.)
The Europeans, as a group, firmly insisted upon a “risk based” approach, seemingly more sophisticated because it calculated assets based on how risky they seemed to be. They felt it was common sense that certain kinds of assets-certainly including domestic government bonds but also home mortgages and other sovereign debt-shouldn’t require much if any capital. Commercial loans, by contrast, would have strict and high capital requirements, whatever the credit rating might be.
Both approaches could claim to have strengths. Each had weaknesses. How to resolve the impasse?...
The Fed and the Bank of England came to a bilateral understanding, announced in early 1987… It became known as the “Basel Agreement” …
Over time, the inherent problems with the risk weighted bank capital-based approach became apparent. The assets assigned the lowest risk, for which capital requirements were therefore low or nonexistent, were those that had the most political support: sovereign credits and home mortgages. Ironically, losses on those two types of assets would fuel the global crisis in 2008 and a subsequent European crisis in 2011. The American “overall leverage” approach had a disadvantage as well in the eyes of shareholders and executives focused on return on capital; it seemed to discourage holdings of the safest assets, in particular low-return US government securities.
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