How come we ended up with stupid portfolio invariant risk weighted bank capital requirements?

Which are based on:

That those excessive exposures that can really be dangerous to our bank systems are build up with assets perceived as risky and not with assets perceived as safe.

That the bureaucrats/politicians/apparatchiks know better what to do with credit they’re not personally responsible for than e.g., entrepreneurs

That so much of bank capital requirements can depend on the evaluation performed by some very few human fallible credit rating agencies.

That substituting risk adjusted returns on equity for risk adjusted interest rates, would not seriously distort the allocation of bank credit.

Well here is the seed “A Risk-Factor Model Foundation for Ratings-Based Bank Capital Rules"

And here is Basel Committee’s “An Explanatory Note on the Basel II IRB Risk Weight Functions"

Though Paul A. Volcker, in his autography “Keeping at it”, valiantly confessed “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”

And here my explanations:

All bank regulators faced/face a furious attack mounted by dangerously creative capital minimizing / leverage maximizing financial engineers, who, getting rid of traditional loan officers, those with their “know your client” and their “what are you going to use the money for?”, managed to capture the banks. (And, since less capital means less dividends, they can also pay themselves larger bonuses.)

Hubris! “We regulators, we know so much about risks so we will impose risk weighted capital requirements on banks, something which will make our financial system safer” Yep, what’s risky is risky, what’s safe is safe. What is there not to like with such an offer? And the world, for the umpteenth time, again fell for demagogues, populists, Monday morning quarterbacks and those who find it so delightful to impress us rolling off their tongues sophisticated words like derivatives.

In a world full of mutual admiration clubs, like the Basel Committee and Academia in general, you do not ask questions that can imply criticism of any of your colleagues or superiors, “C’est pas comme il faut», nor, if you are a high shot financial journalist, do you risk not being invited to Davos or IMF meetings.

"It is difficult to get a man to understand something, when his salary depends upon his not understanding it!" Upton Sinclair

Clearly there are many more jobs with ever growing thousands of pages of regulations than with just a one liner: “Banks shall have one capital requirement (8%-15%) against all assets”. And so, instead of getting rid of the extremely procyclical credit risk weighted capital requirements, they designed new insufficient countercyclical ones.

“The time spent on any item of the agenda will be in inverse proportion to the sum involved." Parkinson’s law

Since bank regulators must have heard of (supposedly) Mark Twain’s “A banker is a fellow who lends you his umbrella when the sun is shining, but wants it back the minute it looks to rain” it is clear they all missed their lectures on conditional probabilities.

“There are some mistakes it takes a Ph.D. to make”, Daniel Moynihan.

“One has to belong to the intelligentsia to believe things like that: no ordinary man could be such a fool”, George Orwell, in Notes on Nationalism

And so now: 

“A ship in harbor is safe, but that is not what ships are for” John A. Shedd, something that should apply to banks too. Sadly, dangerously our bank systems, banks are overpopulating safe harbors and, equally dangerous for our economy, underexploring risky waters. 

“What gets us into trouble is not what we don't know. It's what we know for sure that just ain't so.” Mark Twain

And since current bank capital requirements are mostly based on the expected credit risks banks should clear for on their own; not on misperceived credit risks, like 2008’s AAA rated MBS, or unexpected dangers, like COVID-19, now banks stand there with their pants down.

Let us pray 2021 will not be too hurtful.

PS. Might “availability heuristic” “availability bias” help explain these loony risk weighted bank capital requirements?

My 2009 video on the 62.5 times to 1 authorized leverage

My 2019 letter to the Financial Stability Board

My 2019 letter to the Executive Directors and Staff of the International Monetary Fund

I’ve never been a regulator, but on the issue, neither am I a new arrival.

And the regulators’ mumbo jumbo, shows no sign it will stop.

My very brief summary of Basel I, II, III history... and my hopes for a future Basel IV

1988 Basel I (30 pages) decreed risk weighted bank capital requirements with risk weights of 0% the sovereign and 100% citizens, which de facto indicates bureaucrats know better what to do with credit they’re not personally responsible for than citizens.

http://subprimeregulations.blogspot.com/2015/07/just-before-fall-of-berlin-wall.html

2004 Basel II (251 pages), (creative capital minimizing/leverage maximizing financial engineers, fooled regulators into believing that the buildup of those excessive exposures that could endanger our bank systems, is done with assets perceived as risky.

https://subprimeregulations.blogspot.com/2020/10/any-risk-even-if-perfectly-perceived.html

2010 Basel III (the current version has so many pieces it’s hard to say how many pages it contains but it's at least 1.600), some small gestures of rationality like a leverage ratio and countercyclical capital buffers BUT, on the margins of bank capital requirements, which is where it most counts, Basel I's and Basel II's distortions are alive and kicking.

http://subprimeregulations.blogspot.com/2019/03/my-letter-to-financial-stability-board.html

202X Basel IV, lets pray they throw Basel I, II and III out, and set a fix bank capital requirement of 10%-15% on absolutely all assets. That would allow the so much needed traditional bank loan officers to return to the banks

https://subprimeregulations.blogspot.com/2013/01/confessions-of-monstrous-banker.html

Small businesses (like restaurants) besides Covid-19 lockdowns, when it comes to bank credit, these have also for a long time suffered lockouts

Before Basel Committee’s risk weighted capital requirements, if a residential mortgages and loans small businesses produced the same risk adjusted expected net margin/return on asset (eROA), these would produce the same risk adjusted expected returns on equity (eROE)

That was then: Now, with Basel III a residential mortgage with e.g., a loan to value of 80% to 90%, has a risk weight of 40%; which times the basic 8% requirement, results in a capital requirement of 3.2%, which allows banks to leverage 31.25 times their capital (equity).

While a loan to small businesses have a risk weight of 100%; which results in a capital requirement of 8%, which allows banks to leverage 12.5 times their capital.

So, if the eROA for residential mortgages and loans to small businesses is 1%, then residential mortgages produce a eROE of 31.25%, while loans to small businesses only a eROE of 12.5%

And so, even if interest rates on residential mortgages were reduced by e.g. 0.5%, resulting in a lower risk adjusted expected ROA of 0.5%, residential mortgages, yielding banks a 15.625% risk adjusted eROE, would still be more interesting to banks than loans to small businesses

And therefore, small businesses, in order to access credit, must pay higher interest rates so as to increase the expected risk adjusted ROA, in order to produce banks a competitive risk adjusted eROE.

And so, though the less creditworthy (small businesses/entrepreneurs) always got smaller bank loans and paid higher interest rates but, with risk weighted bank capital requirements, the regulator also decreed them to be less worthy of credit.

What’s the net result of all this? Too much credit at too low interest rates for the purchase of houses, and too little credit to the small businesses/entrepreneurs who could generate the jobs/the incomes/the down-payments, for house buyers to service their mortgages and pay food and utilities.

Conclusion: The risk weighted bank capital requirements have, de facto, 0% to do with credit risk reduction, and 100% to do with risk generating distortions.

Basel Committee… Good Job!

PS. There has too be and adequate equilibrium between risk-avoidance and the risk-taking needed to sustain growth.

http://subprimeregulations.blogspot.com/2019/03/my-letter-to-financial-stability-board.html

The Basel Committee for Banking Supervision’s dangerous distortion of the allocation of bank credit, all explained for dummies in just four tweets.

If a safe borrower’s 4% and a riskier borrower’s 6% provide banks the same 1% risk adjusted net margin then, before the introduction of BCBS’s credit risk weighted capital requirements, those would have been the rates charged by banks.

But now, because the “safer” can e.g. be leveraged 25 times while the riskier e.g. only 12.5 times, with those initial rates, the safer will provide banks a 25% risk adjusted return on equity, while the riskier only 12.5%.

So, now the safer could be offered less than a 4% rate, even down to 3.5% (new risk adjusted net margin of .5%) and still be competitive vs. the riskier when accessing bank credit, and/or be awarded too much credit… which could (will, sooner or later) turn him risky.

And the riskier will now have to pay 7% (new risk adjusted net margin of 2%) in order to remain competitive vs. the safer, which would make him even riskier, or not have access to credit at all, which could hurt the growth possibilities of the real economy

1988, when it all started, when statism/communism took over our bank system.

2019, my letter to the Financial Stability Board

Basel Committee’s members, when will they ever learn, when will they ever learn?

On their own, banks would naturally charge higher interest on residential mortgages to those with higher loan to value ratios (LTV) than to those with lower LTVs. 

But with Basel III, the first will be charged even higher rates, in order to compensate for the fact that banks are now allowed to leverage more with lower LTVs; which means it's easier for banks to obtain higher risk weighted returns on equity with “safer” lower LTVs.

That makes the riskier even more risky, and, by lowering the risk adjusted interest rate they would pay without this regulatory distortion, could even turn the “safer” into becoming very risky. 

When will the Basel Committee ever learn that any risk, even if perfectly perceived, will lead to the wrong responses, if excessively considered?

When will the Basel Committee ever learn that what’s dangerous to our bank system is not what’s perceived as risky, but what’s perceived as safe?

About prices in kid’s lemonade stands and interest rates on sovereign debt

If a mother gives her children lemons for them to make lemonade to sell, and then their grandfather comes to their stand and buys lemonade at an extravagant price, would any economist refer to that as the market price of lemonade in lemonade stands? I hope not.

And if regulators allow banks much lower capital requirements when holding Treasuries/Gilts than when holding loans to citizens, and then Fed/BoE with their quantitative easing, QEs, buys up loads of Treasuries/Gilts, are the low interests on these, free market rates?

http://subprimeregulations.blogspot.com/2015/07/just-before-fall-of-berlin-wall.html

@PerKurowski