Sunday, December 20, 2020

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.