Do the risk weighted bank capital requirements make the risky more or less risky?
Basel III’s bank capital requirement’s risk weights (RW) for residential mortgages depending on Loan to Value (LTV); implied Allowed Leverage of capital/equity (AL) and expected Return On Equity (eROE), calculated with a Risk Adjusted 0.5% expected Return on Asset (eROE)
LTV<50%: RW = 20%: AL = 62.5 to 1: eROE = 31%
50% < LTV ≤ 60%: RW = 25%: AL = 50 to 1: eROE = 25%
60% < LTV ≤ 80%: RW = 30%: AL = 41.7 to 1: eROE = 21%
80% < LTV ≤ 90%: RW = 40%: AL 31.25 to 1: eROE = 16%
90% < LTV ≤ 100%: RW = 50%: AL 25 to 1: eROE = 12%
LTV > 100%: RW = 70%: AL 17.9 to 1: eROE = 9%
Those with higher LTV, because they are riskier, must naturally pay banks higher risk adjusted interest rates. But, since banks can hold less capital against lower LTVs, they must also compensate banks, so as to provide these with a competitive risk adjusted return on equity.
So, in order for those who have no money to put down (LTV) > 100%, and with which banks can leverage 17.9 times, in order to compete with those who put down LTV <50%, need to provide an expected Risk Adjusted Return on Asset of 1.73 (31%/17.9); meaning in this case a 1.23% higher interest rate than without this distortion.
And we ask: charging those who have no money to put down, and who should perhaps not even have access to a residential mortgage, a 1.23% higher interest rate than what their risk adjusted interest rate would otherwise be, does that make these more or less risky?
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.
If race can be correlated to higher LTV mortgages, does this not de facto imply regulators are engaged in discrimination based on race?
Basel Committee... Good Job!
And we must also ask, are the risk weighted bank capital requirements really in accordance with the spirit of the Equal Credit Opportunity Act (ECOA) or the Community Reinvestment Act (CRA)?
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